Life-Cycle Funds

Abstract

This paper reviews recent advances in academic models of asset allocation for long-term investors, and explores their implications for the design of investment products that help investors save for retirement, particularly life-cycle funds and life-style (or balanced) funds. The paper argues that modern portfolio theory provides scientific foundation for the risk-based asset allocation strategies and the age-based asset allocation strategies that characterize life-style and life-cycle funds. Risk-based allocation strategies can be optimal in an environment where investors face real interest rate (or reinvestment risk), while human wealth considerations give rise to horizon effects in asset allocation. However, this theory also makes a number of suggestions about how life-style and life-cycle funds should be structured, and shows for which types of investors these funds are appropriate investment choices. Thus, modern portfolio theory provides only qualified support for these funds. Nevertheless, the paper argues that properly designed life-cycle funds are better default investment choices than money market funds in defined-contribution pension plans. The paper also argues for the creation of life-cycle funds that allow for heterogeneity in risk tolerance, and for the creation of life-cycle funds specific to defined-contribution plans that can better account for the correlation between human capital and stock returns. It also suggests that investors who expect to receive Social Security benefits and pension income after retirement should choose a target retirement date for their funds based on their life-expectancy, not their expected retirement date.