Australian Financial Review: life cycle funds prepare for their time in the sun

Smart Money, Australian Financial Review, June 2012

As an investor at 25, your needs and expectations are different than those of an investor at 75. That sounds self-evident, but you wouldn’t know it from the nation’s typical superannuation fund, where the default option – which is what 80% of us use – will keep you in the same equity-heavy allocation from the day you start earning to the day you stop breathing.

This makes little sense. Somebody at the start of their earning career can afford to take some risks with their super: a stock market downturn might look ugly in the short term but doesn’t matter so much when one is thinking 40 or 50 years ahead. But for those approaching retirement, a major shift in the value of the assets at the wrong moment can be utterly debilitating – perhaps the cruellest lesson of the global financial crisis. For them, the emphasis would logically be on preservation, with a more conservative approach to growth.

Life cycle and target date funds seek to address these shifting priorities by changing your fund’s allocation as you move through life. When young, they put you more heavily in equities; when older, they step up the amount of your money in safer debt securities like bonds. In their simplest form, this takes place in a quite arbitrary way, usually on a specific birthday.

In the USA this approach has been commonplace for years, with mixed results (see box). It is rarer in Australia, but becoming more commonplace, in a fairly blunt way. If you are a default investor in Telstra Super Personal Plus, for example, and make no other investment choice, you will be placed in a balanced option for most of your working life (targeting 74% growth assets and 26% what it calls financial assets, such as bonds and cash) and automatically shifted to a conservative option at the age of 60, moving to a 40/60 growth/income split. At Health Super, if you don’t make an investment choice, you are put in a long-term growth portfolio (90/10) up to the age of 50, a medium-term growth (70/30) allocation for the next 10 years, and balanced (50/50) from age 60 onwards. Health Super writes to members before making the switch, but that apart, it happens automatically on their birthday.

These approaches stem from a recognition of just how important the last years – or even just the last year – of a lifetime of accumulation can be. Investment professionals talk a lot about sequencing, or sequential risk; this refers to the fact that the moment when an investor experiences market performance greatly influences outcomes – so, for example, experiencing the GFC in an equity-heavy portfolio when on the cusp of retirement would be a nasty example of sequencing risk. The idea of moving into safer assets later in the life cycle is to remove some of this sequential risk and protect the wealth that’s already been built up.

In this interpretation, the hot topic of whether we’ve all got too much in equities is missing the point. “That’s asking the wrong question,” says Professor Michael Drew, Professor of Finance at Griffith Business School. “We seem to have framed this discussion in Australia around the 70/30 default options, which four out of five members are in, and which give you the same allocation whether you’re 15 or 85.” In fact, the answer depends on what end of that range you’re at. “If you have a 40 year horizon, equities sound pretty sensible. If you have a short horizon before drawing on your retirement savings, they might not.”

Viewed like that, the life cycle approach makes a lot of sense. But not everyone is a fan. Some in the industry, mocking the arbitrary nature of a birthday as a pivotal investment moment, call them “astrological funds” or “drop-kick funds”, referring to the sudden shifts in allocation they impose. They draw particular fire in financial planner community, which sees itself as a more informed gauge of when people should change their investments.

“I am not a supporter of life-cycle strategies as they currently stand,” says Paul Moran of Paul Moran Financial Planning. “These strategies are all activated without a view to current market conditions. Portfolio changes occur based simply on the client’s birthday. There is a risk in this itself, as changes may be at exactly the wrong time – or exactly the right time – but they are always based on a factor that has absolutely nothing to do with investment markets: the investor’s age.”

To Moran, this is just missing the point. But they are arguably better than nothing. “Life cycle strategies are perhaps suited to naïve investors who pay little attention to their investments,” he says. “In the absence of getting some advice regarding asset allocation based on their personal circumstances, this may at least play the cautious card.”

It seems many in the planning community remain unconvinced. According to the research group InvestmentTrends, which published a study on retirement planning in April, less than 1% of Australian financial planners said they had used life cycle or target date funds in 2011, and only 4% said they would use them in 2012 if they were made available to them.

Still, Moran’s objections, while relevant to lifecycle funds as they exist today, are not lost on product manufacturers who in some cases are already thinking along exactly these lines. Work is already well underway on a second generation of life cycle funds that take some of these concerns into consideration.

An example is QSuper. CEO Rosemary Vilgan says the fund is developing a life cycle approach, which will become its default fund, probably later this year. “Where we’re heading to is life cycle investing, but mark two,” she says.

Meaning? Well, partly recognising that age is not the only differentiator among members. “Members have different profiles, so putting everyone into the same balanced fund doesn’t take account of two key things: members’ time to retirement, which age is a proxy for, and the amount of money people have.” It will also be more market-aware than funds that shift allocations arbitrarily on a birthday, instead taking account of market conditions. “Where our research has taken us following the GFC is to get closer to recognising members’ outcome needs: stable retirement income. Things like measuring against your peers – and we are one of the top ranking funds – are not all that relevant to getting to the right retirement outcomes.”

Russell Investments recently published a paper on life cycle funds calling for exactly the sort of changes that QSuper is working on. “Lifecycle investing isn’t simply about reducing allocations to growth assets with age,” the paper says. “Additional demographic and financial information must be considered in addition to age”. Russell suggests that new life cycle funds should create customised life cycle strategies for each member based not only on age but on income level, total account balance in super, current savings rates, total wealth, and the nature of their job.

The idea is to recognise, as Russell points out, that not only is the same default investment strategy appropriate to a 40 year old and a 75 year old, but the same default strategy may also be inappropriate for two different 75 year olds with different account balances and spending requirements. This is a big ask for manufacturers to deliver in a cost-effective way, though; the industry term is mass customisation, and it is going to be reliant on technology somewhat reminiscent of a Google algorithm.

Opinion is divided on just how easy that’s going to be to achieve. Russell argues that much of this information is available on an investor’s administration platform. “I can only speak on behalf of our own platform, but there is a richness of member information there that can be used to create a more dynamic and thoughtful investment approach,” says Chris Corneil, Russell Investments’ Australia CEO. Another manager, who has worked on trying to implement life cycle strategies using this information, disagrees, saying “accessing all that data on a platform would be nirvana”.

For her part, Vilgan draws a parallel with Amazon, “who try to understand customer needs and talk to them about those needs. This is happening in every other business, it’s just that the pension world hasn’t caught up. We believe this is a 20, 30, even 50 year vision.” At the far extreme, US-based fund manager Dimensional is understood to be considering bringing technology to Australia which would create a truly individual, yet largely automated, allocation for every single member. While admiring the principle, one manager says: “That’s life cycle version seven. We’re still working on version two.”

Life cycle investing is under particular scrutiny now as we move closer to the launch of MySuper default products. It’s still, somewhat alarmingly, unclear just what the final legislation for MySuper will eventually say, but if draft bills go through as proposed then life cycle funds will certainly be permitted as defaults, and will be allowed to operate based on parameters other than age, provided APRA approves them. There is a sense that, just as the US has allowed life cycle options in its 401K defined benefit plans, the time is right to bring life cycle ideas to the masses in Australia. “Nobody is suggesting life cycle funds should be mandatory,” says one fund manager. “But if in July 2013, after all the effort of the Cooper review and so on, all we end up with is the same funds we already had, that will not be in the spirit of change we were expecting.”

“After 20 years of the superannuation investment management industry, nearly everyone has exactly the same 70/30 allocation for life,” he says. “Are we not smarter than that?”

Discussion of MySuper brings us to the fee question: since the single biggest driver of government policy on MySuper has been low cost, is a life cycle format achievable?

Probably the best indication that it is comes from BT, which despite being a commercial operation – commonly considered higher cost than industry funds – has managed to launch a successful life cycle product at a fee of just 0.99%, around the level the government wants to see in default funds. BT’s Super for Life product, which takes investors through super into a transition phase and then into a retirement product, offers its Life Stage product as an investment option; Melanie Evans, who heads the superannuation and platforms team at BT, says that four out of five customers who join directly take the option up. “We’re not surprised at that result,” she says. “When we researched this five or six years ago prior to launching, we found that most Australians understood they needed dynamic asset allocation over time, but acknowledged they didn’t have the technical capabilities, knowledge or time to do it themselves.”

The BT approach is to divide investors by their decade of birth and set an asset allocation accordingly. So, if you were born in the 1990s, BT would currently have you 90.18% in growth assets and 9.82% defensive; if you were born in the 1940s, very likely putting you in retirement or approaching it, you would be 34.69% in growth and 65.31% defensive. The other decades taper between these two extremes.

Her comment on Australians knowing they need to do something but not having the time or knowledge to do it is important to consider alongside Moran’s view that financial planners are better equipped to tell people when to move their money. In fact, there is room for both to be right. “BT Super for Life is specifically designed for a segment of the market that doesn’t necessarily have access to a personalised financial planner from a professional financial planner,” Evans says. “It’s not designed to take the place of that, nor do we say it is equivalent to a customised financial plan. It is for those people who would otherwise be taking a typical default investment strategy. Vilgan takes a similar view. “This will help people get better engaged with their superannuation. I don’t think this undercuts financial planners, and for those who can engage with them, that’s wonderful; but for the ones that don’t engage, we want to put them on the best path.”

There’s no question life cycle products are going to gain traction. Vilgan, looking five years ahead, says she can imagine the approach being dominant in super funds. And asset consultants like Watson Wyatt, Mercer and Russell are talking with funds about the approach every day. “We know a number of organisations that are considering life cycle,” says Tim Furlan, director of superannuation at Russell. “They’re probably not the majority at this stage, but there are many who are thinking: is this something we should be doing?”

So expect your super fund to be looking at life cycle approaches, and be ready to see exactly what they’re offering. Because autopilot, you might say, is a great invention provided you’ve got somebody there who knows when it’s a good idea to turn it off.

BOX: The international experience

Life cycle funds are relatively new in Australia but have a fairly long history in the USA, where they first appeared in the early 1990s. They have really flourished since a change of US legislation in 2007, which allowed life cycle funds to qualify as default investments in 401(k) defined contribution plans; by December 2011 life cycle funds in the USA had US$381.7 billion under management. Cerulli Associates predicts the figure will reach $1.1 trillion by 2016, and the UK’s workplace pension scheme has chosen life cycle investing as a default option for members too, suggesting similar growth there in future.

If the US shows us the future in asset growth, it also sends some chilling messages about the downside of these funds. Since most life cycle funds in the USA follow the prescriptive, birthday-based approach to changing asset allocation, rather than anything nuanced by what markets are doing at the time, many of them did exactly the worst thing to their investors during the financial crisis. “In 2008 they were blindly switching members’ asset allocations at the worst time,” recalls one fund manager. “If you were switched out of equities at the bottom of the market in February 2009 – as many were – by the time you got your statement in October and said that wasn’t the strategy you wanted, you would have missed the rally.”

This experience was so widespread and so damaging that the Securities and Exchange Commission and US Department of Labor held hearings into the products later in 2009. Among the people asked to give testimony was Griffith University’s Professor Michael Drew.

“During the GFC the 2010 target date cohort – people retiring in 2010 – had a range of return outcomes from negative 3% to negative 40%,” he recalls. “Imagine you’re two years out from retirement and receive a negative 40% return.”

The conclusion was that while these products offered a degree of agreeable simplicity for members who weren’t deeply engaged in their retirement savings, there ought to be more to them than age or retirement date.

Today, Drew says funds think of risks over three horizons: long-term, which is the policy decision on the outcome a member is trying to achieve (such as, say, a retirement balance of eight to 10 times their salary); medium term risk, of five to seven years, which is where dynamic asset allocation – deciding whether it’s a good time to shift into bonds, 60^th birthday or not – comes in; and sequencing risk, which relates to the impact of market movements depending on when they happen. “For the average member, if you have a fall of markets in 25% in the last five years of your working life, it can be equivalent to one and a half times your lifetime contributions to super,” he explains. “The pithy quote is: what’s safe and what’s risky changes over your life.”

These horizons are exactly the sort of things groups like QSuper, QIC and Russell are talking about in the main story. But while US funds are changing some of their approaches, this too is causing some concern.

In the US, and increasingly here, the vernacular to refer to changing allocations over time is known as a glide path. If you see a chart, showing how the equity component of a fund fades as you get older, you understand the term: it looks like a plane coming into land. These charts and paths are instrumental in how Americans choose their funds.

But research group Morningstar published a detailed study of glide paths in the US in September, finding that glide paths were being changed unpredictably. “Unfortunately, the glide path that [investors] signed up for may not be what they are actually receiving,” Morningstar concluded. “While it is widely known that the equity exposure of funds with the same target date vary significantly from one family to the next, investors and plan sponsors are less aware – arguably unaware – that the glide path from a single manufacturer can change dramatically over time, often with no explanation.”