The concept of matching asset allocations to individuals’ risk preferences has been around for many decades now and has developed significantly over time. As the theory developed, the concept of lifecycle investing – varying asset allocation according to an individual’s age – was born.
Written by Oliver Warren, Investment Solutions Consultant at Aegon Asset Management and Gosse Alserda, Investment Strategist at TKP Investments.
This publication is the first in a series in which we will explore some of the factors influencing lifecycle construction and consider how Defined Contribution (DC) pension schemes may incorporate them into their lifecycle construction process.
Risk preferences vary between individuals and, in the pensions context, measure the extent to which people are happy to take greater risk in exchange for higher expected returns. Determining people's risk preferences allows us, in addition to purely looking at the monetary value of a given pension outcome, to also look at the utility which people will get out of that pension outcome. Risk averse investors will place greater value on the certainty of their pension outcome and will be prepared to forgo a higher potential pension for this certainty. Risk tolerant investors, on the other hand, are willing to take greater risks for a higher potential pension.
Adding human capital to the equation
Lifecycle investing theory began by looking purely at investors' financial capital. Under some models, this led to a percentage allocation to risky assets which was independent of age and based solely upon their individual risk preference. Towards the end of the last century, pension providers also started to consider investors' human capital, which in this context is defined as the value of their future earnings (e.g. salary or other income payments). In doing so, the principle of de-risking investment strategies as investors approach retirement emerged, a principle that is now well established amongst DC pension providers.
Figure 1: Illustration of the development of human and financial capital over lifetime.
Rules of thumb for lifecycle construction
For many years, simple rules of thumb have been proposed to help investors allocate their investments, often in order to achieve a certain risk-return profile. For example, a fixed 50% equities and 50% bonds allocation is often cited as a suitable long-term investment strategy. Other rules of thumb adopt the commonly held principle that investors should reduce risk in their portfolios as they age. There are several reasons for this, such as:
- a shortening investment horizon gives less time to ride out equity market crashes;
- people reaching retirement will want an income from their investments and will want more certainty over the level of this income; and
- a potential increase in risk-aversion with age.
Another reason is the decrease over time in people's "human capital" which in turn implies less risk should be taken with their financial capital.
Lifecycle investing can quickly become very complex from a theoretical viewpoint and provides fertile ground for academic research. In the industry, whilst the principle of de-risking towards retirement age has been contested by some researchers, it is relatively well established and is supported by a large part of the academic literature, in particular on the basis of models invoking human capital.
Potential lifecycles can be assessed and compared using ALM as well as on the basis of historic performance. Pension income (generally measured in real terms) is likely to be the outcome measure of most interest although other outcomes may also be appropriate. Additionally outcomes can be mapped to utility values in order to take into account the value that investors with different risk preferences will place on these outcomes.
We argue an approach based upon the principle of de-risking as investors approach retirement is appropriate and that ALM provides the best tool to optimize the precise shape of the lifecycle paths and asset allocations. If appropriate, the asset allocations can also be varied over time to take into account changing market conditions.
Developments in the future
Lifecycle investing is developing relatively quickly, driven by the shift from DB to DC in many countries and the introduction of a wider range of options for pension savers, notably the ability to continue investing after retirement. In this fast-developing DC landscape, pension funds and providers need to regularly review the lifecycles they offer to ensure they remain appropriate as the market develops. Lifecycle solutions are likely to continue to evolve over the coming years.