Fix lifecycle, don’t scrap it

Lifecycle products were developed in Australia following the market downturns in the Global Financial Crisis (GFC).  Some members approaching retirement had a reduction of 20% of their superannuation benefit and the new products were designed to reduce the loss for members experiencing similar events in the future.

Some members did not understand the asset allocation of their default superannuation investment and responded with the primal ‘flight’ reflex – withdrawing their retirement sums from balanced options and investing in cash – crystallising their returns.

Many providers took the introduction of MySuper as an opportunity to redesign their defaults to avoid a repetition of this effect when the markets repeated their cycle.

The Productivity Commission (PC) recently put lifecycle investments in the firing line, questioning whether they should be allowed as a MySuper (default) option.  If so, the PC asked:

• “Do they require re-design to better cater for the varying circumstances of members nearing retirement, and how should this be achieved?
• What information is needed on members to develop a product better suited to managing sequencing risk?”¹

The Productivity Commission’s modelling of lifecycle investments² canvasses the negatives of lifecycle investment strategies based on current products in the market.  It shows a large downside in terms of foregone returns from de-risking too early.  The Commission’s work also demonstrated limited protection for members, because when market events occur these options do still have non-trivial growth exposures.  These findings are not surprising, in fact Rice Warner has commented on this before in 2016³.

But, not all lifecycle products are created equal.  The results of the PC’s modelling are a symptom of design, not an encumbrance of the concept.

Arguably, a lifecycle product with a full allocation to growth in the formative years, de-risking to the ‘more appropriate’ balanced fund supported by the PC ten years out from retirement will produce superior results, with only a marginal increase in risk for the member.  Alternatively, members could move money into a cash account for any lump sum required at retirement and the first year’s pension payments.  This will allow them to keep high levels of growth assets as they will not need to draw down on the main account, so they are immunised against a market shock at the time of retirement.

This simple example illustrates why design matters.  But what other factors are at play?

Factoring in behaviour

Factoring in the likely behaviour of some members, even though irrational, is an important consideration in product design.

Take for example NEST (the UK based default pension fund), which invests a member’s initial contributions (which are quite small) for five years in cash.  The overall impact on the final balances is limited given the small initial balances, however, NEST argues that the formative years of the member’s engagement with NEST are about building trust.  Behavioural economics at play.

This is not to say that products should be designed sub-optimally because of likely member reactions to market falls.  However, it is an undeniable fact of life and something trustees need to consider.

Going beyond lifecycle

Technology, particularly improvements in administration and member services are driving a trend towards smarter, more personalised defaults.  Not simpler ones.  We can already see this occurring in Australia with some funds providing/considering lifecycle products that vary with balance and age.

Access to more data will allow funds to segment membership into homogenous groups using age, gender and account balance as relevant factors.  Using historical exit data, we can predict when members will retire and how much they will need as a lump sum.

Rice Warner has suggested tailoring defaults using such factors and a simple bucketing strategy⁴ . For each member, over the five years to retirement, a fund can set a strategy to shift money into cash for liquidity purposes based on this information.

During retirement, algorithms can move more money into cash when the fund is performing well.  Further, a member’s personal financial needs can be assessed periodically, and the amount of pension payments and the asset allocation can be reviewed.

Therefore, it’s imperative that the PC’s findings, though correct, should not lead to a ban on lifecycle investments.

Lifecycle does not need to be relegated to the dustbin.  It just needs a redesign.

¹ Productivity Commission Superannuation: Assessing Efficiency and Competitiveness, 2018, Draft report pg. 49 https://www.pc.gov.au/__data/assets/pdf_file/0003/228171/superannuation-assessment-draft.pdf
² Productivity Commission, Superannuation: Assessing Efficiency and Competitiveness, 2018, Technical Supplement 6 – Analysis of members’ needs https://www.pc.gov.au/__data/assets/pdf_file/0019/228250/superannuation-assessment-draft-supplement6.pdf
³ Rice Warner, Lifecycle MySuper Product Fees, prepared for AIST, 2016 http://www.aist.asn.au/media/860083/lifecycle_mysuper_product_fees.pdf
⁴ See Rice Warner’s Beyond Lifecycle investment approach, Investment Magazine, 2013 https://investmentmagazine.com.au/2013/01/some-questions-for-michael-rice/ and https://www.ricewarner.com/default-pension-portfolios-different-needs-require-different-buckets/