Lifecycle Funds Research Articles

Dynamic preferences for popular investment strategies in pension funds

In this paper, we characterize dynamic investment strategies that are consistent with the expected utility setting and more generally with the forward utility setting. Two popular dynamic strategies in the pension funds industry are used to illustrate our results: a constant proportion portfolio insurance (CPPI) strategy and a life-cycle strategy. For the CPPI strategy, we are able to infer preferences of the pension fund’s manager from her investment strategy, and to exhibit the specific expected utility maximization that makes this strategy optimal at any given time horizon. In the Black–Scholes market with deterministic parameters, we are able to show that traditional life-cycle funds are not optimal to any expected utility maximizers. We also prove that a CPPI strategy is optimal for a fund manager with HARA utility function, while an investor with a SAHARA utility function will choose a time-decreasing allocation to risky assets in the same spirit as the life-cycle funds strategy. Finally, we suggest how to modify these strategies if the financial market follows a more general diffusion process than in the Black–Scholes market.

Portfolio Strategies in Decumulation Phase: Does Lifecycling Fail?

We compare the performance of the commonly nominated default retirement investment option, the lifecycle fund, to alternative investment strategies during retirees' decumulation phase. Under different shortfall risk measures, we find balanced portfolios with constant exposure to equities, equity dominated portfolios as well as 'reverse lifecycle' portfolios that increase exposures to equities over time to consistently outperform the conventional lifecycle portfolio. While an increasing equity glidepath improves the performance of an investment strategy, the starting asset allocations are equally important. Using a utility-of-terminal wealth approach which allows for loss aversion as discussed in prospect theory by Kahneman and Tversky (1979), we find the Growth portfolio to dominate the alternative strategies at low and moderate thresholds. With increasing wealth threshold levels, a strategy with all equity allocations become dominant. The lifecycle portfolio is dominated by the 'reverse lifecycle' portfolio at all threshold levels.

Are lifecycle funds appropriate as default options in participant-directed retirement plans?

Since the enactment of Pension Protection Act of 2006, lifecycle funds that reduce exposure to stocks with age have rapidly replaced money market funds as the most commonly nominated default investment options for participant-directed retirement plans. We examine their appropriateness in meeting a threshold level of retirement wealth required by plan participants. Using a utility function motivated by prospect theory (Kahneman and Tversky, 1979), we show that whilst lifecycle funds are vastly superior to money market funds (except for very low thresholds), they rank below balanced funds that maintain constant exposure to equities over time. As thresholds increase, lifecycle funds are also dominated by funds that switch assets conditional to prior investment performance. Even in the absence of a minimum threshold wealth level, lifecycle funds do not emerge as the most preferred choice among the investment options considered by our paper.

Aging Population, Retirement, and Risk Taking

The increase in life expectancy spells disaster at retirement. One can solve this problem by investing in the maximum geometric mean (MGM) portfolio, which is empirically composed from equity. For a T = 30 year horizon or more, the MGM portfolio dominates other investment strategies by almost first-degree stochastic dominance. The MGM portfolio also maximizes the expected value of the commonly employed preferences and prospect theory value function, for various loss aversion parameters and various reference points, for T ≥ 10. Life-cycle funds would increase virtually all investors’ welfare by shifting to the MGM portfolio so long as the investment horizon is at least 10 years. This paper was accepted by Amit Seru, finance.

Asymptotic Stochastic Dominance and the Maximum Geometric Mean Strategy

The increase in life expectancy spells disaster at retirement. One can solve this problem by investing in the maximum geometric mean (MGM) portfolio, which is empirically composed from equity. For a T = 30 year horizon or more, the MGM portfolio dominates other investment strategies by almost first-degree stochastic dominance. The MGM portfolio also maximizes the expected value of the commonly employed preferences and prospect theory value function, for various loss aversion parameters and various reference points, for T ≥ 10. Life-cycle funds would increase virtually all investors’ welfare by shifting to the MGM portfolio so long as the investment horizon is at least 10 years.

Life Cycle Investing: From Target-Dateto Goal-Based Investing

The authors propose the use of goal based investing—or private ALM, as they prefer to call it—to tailor a dynamic investment strategy to the needs of individual clients. They argue that this approach is superior to the “one-size-fits-all,” target-date-oriented static allocation path used in most current life cycle funds. They present the two pillars of their approach: the methodology for obtaining financial and economic scenarios, and the methodology of the goal-oriented dynamic allocation strategy. This approach reduces the risks and improves the feasibility of meeting the clients’ goals. <b>TOPICS:</b>Retirement, portfolio construction, simulations

Plan Format and Participation in 401(k) Plans: The Moderating Role of Investor Knowledge

There is continuing concern that many people are not saving enough for retirement. The authors conduct three studies to determine whether simple alterations to the format of 401(k) plans can increase plan participation rates, especially among people with low levels of financial knowledge. In Study 1, offering a larger number of funds for investment reduces plan participation among low-knowledge investors, unless the plan also offers a target retirement date (i.e., life-cycle fund) option. In Study 2, the authors find those with low knowledge are more likely to participate if the funds offered for investment are grouped by asset class rather than listed alphabetically. In Study 3, the authors find that participation increases when fund descriptions include star ratings (but not fund style boxes). They also find that star ratings increase decision satisfaction among low-knowledge investors because of a reduction in perceived task difficulty. Limitations, implications, and further research are discussed.

How to Invest Over the Life-Cycle in the Presence of Background Risk?

This paper investigates the impact of health and labor income risk on portfolio choice in a realistically calibrated life-cycle model. The model shows that health risk reduces the desired exposure to risky assets, consistent with empirical findings. Moreover, the model’s prediction matches empirical evidence, including the labor supply-health-age profile and retirement behavior. Furthermore, extending the model to incorporate the stylized fact that medical expenses of elderly are more volatile than those of younger individuals suggests rebalancing the portfolio so that it becomes more conservative as an investor nears retirement. This investment strategy is consistent with target retirement funds offered by financial advisers, yet the model suggests that the next wave of life-cycle fund designs should focus on both the year and age of retirement rather than only on the year of retirement. In the presence of background risk and a high historical equity risk premium, social insurance and bequest motives play an important role in explaining observed low risky asset holdings and low withdrawals of savings in later life.

Lifestyle or Lifecycle Funds Are They the Answer to Retirement Wealth Creation?

In this paper we investigate whether lifestyle and lifecycle products offered by the mutual fund industry are designed to maximise terminal wealth of investors. The overall findings are that the majority of lifestyle and lifecycle funds are unlikely to produce sufficient capital for investors to live on once they retire. In order to produce terminal balances greater than $1,000,000 one needs to have a high exposure to equities in the 80% to 100% range. Additionally it is wise to contribute at least 10% annually to the fund as this can increase terminal values by at least 40%. However, having a high exposure may cause distress to investors particularly in bear markets, it therefore makes sense to employ a strategy which varies the asset allocation depending upon the time varying nature of markets. The four alternative TAA strategies outlined attempt to take into the account the time varying nature of markets and the results indicate that they produce superior performance relative to lifestyle and lifecycle funds. All dynamic asset allocation strategies dominate by first order stochastic dominance conventional lifestyle and lifecycle funds and should be preferred by investors.

Are Lifecycle Funds Getting a Bum Rap? A Comprehensive Comparison of Lifecycle versus Lifestyle Retirement Strategies from Accumulation through Withdrawal

In an effort to determine whether recent criticism regarding the efficacy of lifecycle mutual funds is justified, this article makes a robust comparison of two glidepath strategies commonly employed in lifecycle funds, both with each other and with a range of constant allocation portfolios designed to simulate risk-based lifestyle mutual funds. A concerted effort is made to make the model design realistic, and the analysis considers the lifecycle and lifestyle strategies through the accumulation and withdrawal phases of retirement planning. The results tend to cast a favorable light on lifecycle funds and suggest that recent research critical of lifecycle funds may be too narrowly focused. By considering a robust range of accumulation and withdrawal scenarios as well as multiple measures of risk, this analysis finds that lifecycle funds may be a rational choice for a surprisingly wide spectrum of workers and retirees. <b>TOPICS:</b>Retirement, mutual funds/passive investing/indexing, performance measurement

The Portfolio Size Effect and Lifecycle AssetAllocation Funds: A Different Perspective

Basu and Drew (in the <i>JPM</i> Spring 2009 issue) argued that lifecycle asset allocation strategies are counterproductive to the retirement savings goals of typical individual investors. Because of the portfolio size effect, most portfolio growth will occur in the years just before retirement when lifecycle funds have already switched to a more conservative asset allocation. In this article, Pfau uses the same methodology as Basu and Drew, but does not share their conclusion that the portfolio size effect soundly overturns the justification for the lifecycle asset allocation strategy. Although strategies that maintain a large allocation to stocks do provide many attractive features, the authors aim to demonstrate that a case for supporting a lifecycle strategy can still be made with modest assumptions for risk aversion and diminishing utility from wealth. Their conclusion differs from the results of previous studies due to four factors: 1) they compare the interactions between different strategies; 2) they consider a more realistic example for the lifecycle asset allocation strategy; 3) they examine the results for 17 countries; and 4) they provide an expected utility framework to compare different strategies. Bruno and Chincarini find that, with a moderate degree of risk aversion, investors have reason to prefer the lifecycle strategy in spite of the portfolio size effect. <b>TOPICS:</b>Retirement, portfolio construction, wealth management

The Portfolio Size Effect and Lifecycle Asset Allocation Funds:A Different Perspective

Basu and Drew (in the JPM Spring 2009 issue) argue that lifecycle asset allocation strategies are counterproductive to the retirement savings goals of typical individual investors. Because of the portfolio size effect, most portfolio growth will occur in the years just before retirement when lifecycle funds have already switched to a more conservative asset allocation. In this article, we use the same methodology as Basu and Drew, but we do not share their conclusion that the portfolio size effect soundly overturns the justification for the lifecycle asset allocation strategy. While strategies that maintain a large allocation to stocks do provide many attractive features, we aim to demonstrate that a case for supporting a lifecycle strategy can still be made with modest assumptions for risk aversion and diminishing utility from wealth. Our differing conclusion results from four factors: (1) we compare the interactions between different strategies; (2) we consider a more realistic example for the lifecycle asset allocation strategy; (3) we examine the results for 17 countries; and (4) we provide an expected utility framework to compare different strategies. We find that with a very reasonable degree of risk aversion, investors have reason to prefer the lifecycle strategy in spite of the portfolio size effect.

Dynamic Lifecycle Strategies for Target DateRetirement Funds

1. Anup K. Basu 1. is a lecturer in the School of Economics and Finance at Queensland University of Technology in Brisbane, Australia. (a.basu{at}qut.edu.au) 2. Alistair Byrne 1. is a principal consultant at Investit Ltd in London, U.K. (alistair.byrne{at}investit.com) 3. Michael E. Drew 1. is a professor of finance in the Department of Accounting, Finance and Economics at Griffith University in Brisbane, Australia. (michael.drew{at}griffith.edu.au) <!-- --> 1. To order reprints of this article, please contact Dewey Palmieri at dpalmieri{at}iijournals.com or 212-224-3675 . Lifecycle funds offered to retirement plan participants gradually reduce exposure to stocks as the funds approach the target date of the participants’ retirement.The authors show that such deterministic switching rules produce inferior wealth outcomes for the investor compared to strategies that dynamically alter the allocation between growth and conservative assets based on cumulative portfolio performance relative to a set target.The dynamic allocation strategies proposed in this article exhibit almost stochastic dominance over strategies that unidirectionally switch assets without consideration of portfolio performance. TOPICS: [Retirement][1], [portfolio construction][2] [1]: https://www.pm-research.com/topic/retirement [2]: https://www.pm-research.com/topic/portfolio-construction

A New Korean Defined Contribution Plan Framework to Enhance Retirement Income Security: Combining Lifecycle Funds with Compulsory Annuitisation

In this paper, the intension is to construct a new Korean defined contribution operation structure that better meets retirement income security by integrating accumulation and payout phases. For this, two approaches are compared: a lump sum withdrawal programme supported by a principal preservation fund (i.e. current approach), and the combination of compulsory annuitisation with lifecycle funds (i.e. alternative approach). We set benchmark incomes, annuity incomes from the immediate life annuity policy, purchasable at retirement with the accumulated assets of lifecycle funds. The above two approaches are then assessed in terms of the probability of shortfall employed here to measure the longevity risk, at a Value-at-Risk of 50, 75 and 95 per cent, respectively. Consequently, it is shown that the alternative approach provides better retirement income security than the current approach.

Lifecycle Funds and Wealth Accumulation for Retirement: Evidence for a More Conservative Asset Allocation as Retirement Approaches

A line of recent studies cast doubt on the efficacy of the lifecycle investment strategy, which calls for switching into a more conservative investment portfolio as retirement approaches, as a suitable way to provide for the retirement needs of workers with defined-contribution pensions. After comparing simulation outcomes for lifecycle and fixed asset allocation strategies, we determine that the lifecycle strategy can be justified even in a framework including only financial wealth. We find that investors with very reasonable amounts of risk aversion may prefer the lifecycle approach, despite the tendency for aggressive fixed allocation strategies to produce larger expected wealth.

Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds?

Lifecycle funds offered by retirement plan providers allocate aggressively to risky asset classes when the employee participants are young, gradually switching to more conservative asset classes as they grow older and approach retirement. This approach focuses on maximizing growth of the accumulation fund in the initial years and preserving its value in the later years. The authors simulate terminal wealth outcomes based on conventional lifecycle asset allocation rules as well as on contrarian strategies that reverse the direction of asset switching. The evidence suggests that the growth in portfolio size over time significantly impacts the asset allocation decision. Due to the portfolio size effect that is observed by the authors, the terminal value of accumulation in retirement accounts is influenced more by the asset allocation strategy adopted in later years relative to that adopted in early years. By mechanistically switching to conservative assets in the later years of a plan, lifecycle strategies sacrifice significant growth opportunity and prove counterproductive to the participant9s wealth accumulation objective. The authors9 conclude that this sacrifice does not seem to be compensated adequately in terms of reducing the risk of potentially adverse outcomes. <b>TOPICS:</b>Retirement, fixed-income portfolio management, in wealth management

Evaluating Target Date Lifecycle Funds

Evaluating Target Date Lifecycle Funds

Default, Framing and Spillover Effects: The Case of Lifecycle Funds in 401(K) Plans

Important behavioral factors such as default and framing effects are increasingly being employed to optimize decision-making in a variety of settings, including individually-directed retirement plans. Yet such approaches may have unintended effects, as we show with regard to the introduction of lifecycle funds in U.S. 401(k) plans. As anticipated, lifecycle funds do reshape individual portfolio choices through large default and framing effects. But unexpectedly, they also create a new class of investors which holds these funds as part of more complex portfolios. Our results are directly relevant to those interested in retirement plan design and retirement security; they also highlight the importance of assessing such spillover effects in other consequential settings where behavioral economics techniques may be employed.

Dynamic Lifecycle Strategies for Target Date Retirement Funds

Lifecycle funds offered to retirement plan participants gradually reduce their exposure to stocks as they approach the target date of retirement. We show that such deterministic switching rules produce inferior wealth outcomes for the investor compared to strategies that dynamically alter the allocation between growth and conservative assets based on cumulative portfolio performance relative to a set target. The dynamic allocation strategies proposed in this paper exhibit almost stochastic dominance (ASD) over strategies that switch assets unidirectionally without consideration of portfolio performance.

Default investment options in defined contribution plans: A quantitative comparison

With the passage of the Pension Protection Act of 2006 and the Department of Labor regulation regarding qualified default investment alternatives, automatic enrollment and default investments featuring more equities are likely to become more popular. This analysis compares the investment performance of a balanced fund and a lifecycle fund, using average asset allocations observed on the market. Simulations show that the balanced fund is more likely to outperform the lifecycle fund, but its more aggressive approach also leaves plan participants vulnerable to losses as retirement approaches. The lifecycle fund is better at safeguarding wealth in a downward market, while still doing a reasonable job of building wealth. The typical lifecycle fund, however, with a large cash position at retirement, forgoes hedging opportunities for the purchase of immediate life annuities. Neither fund is a sure win over the near-risk-free Treasury Inflation-Protected Securities.