This article is intended for professional investors and advisors only
As we see it, effective retirement planning should meet the following basic objective:
- Ensure that a retiree has enough money to support their desired lifestyle for the remainder of their life.
Whilst the goal itself is straightforward, the path towards it requires sound advice based upon realistic assumptions and a commitment from the retiree to invest part of their income for what will in all likelihood be decades.
The role of good financial advice should not be ignored, a good adviser will assist a client to remain on track as their circumstances change, which they inevitably will. We are not financial advisers, and our role is instead to work with advisers to deliver results for their clients. Therefore, if an adviser is responsible for delivering a comfortable retirement to a client, then it is our responsibility to help them do this.
The received wisdom
Occasionally the findings of an academic paper migrate from the obscure pages of a journal into the real world. One reason that such a migration might occur is because the academic research itself directly challenges the received wisdom in an industry.
In late 2023 a paper was published which does just this. In Beyond the Status Quo: A Critical Assessment of Lifestyle Investment Advice[1] the authors directly challenge two of the central pillars of investment planning for retirement, which are:
- Savers should diversify across stocks and bonds and
- The proportion allocated to stocks should reduce with age
This approach is called Lifecycle Investing[2]. In the interests of context, readers should be aware that the paper was written from the point of view of hypothetical American savers, for the purposes of this piece we will call them Joe and Jane Bloggs. Notwithstanding this geographical focus, propositions (a) and (b) will be familiar to advisers and investment managers both here in the UK, and more widely.
How did the authors challenge Lifecycle Investing?
The authors started their analysis by defining what a good outcome for someone at retirement would be.
- Wealth at retirement: Basically, as much as possible
- Sustainability of real income: Retirement income must be reliable and adjusted for inflation[3]. The retention of the purchasing power of post-working life income is paramount
- Conservation of savings: Retirees should not exhaust savings before death
- Bequest: Ideally some savings ought to be left over for beneficiaries
In order to maximise the probability of each of the four outcomes occurring together, the authors used a mathematical simulation technique based upon thousands of monthly return data points for the major asset classes: stocks (foreign [4]and domestic), bonds and cash. Their mathematical model made allowances for several complicating factors in retirement planning, principally gaps in contributions and differences in longevity.
For the sake of comparison, they then modelled the outcomes of other fixed [5]asset allocations and crucially a lifecycle approach where the exposure to equity falls as the saver ages.
What did they find?
The results of the simulation were that a portfolio consisting entirely of stock market investments yielded the best results across all four of the key outcomes set out above. In fact, the optimal allocation was 33% domestic stocks, 67% international stocks, 0% bonds and 0% cash. Furthermore, they found that this combination provided far better diversification benefits than the alternatives.
Astute readers might reasonably observe that over the long-term stocks ought to produce the greatest terminal value at the point of retirement versus a portfolio composed entirely of cash or bonds. They are after all a riskier proposition and consequently the reward for assuming their relative riskiness is the additional reward.
What is surprising is that the optional combination is better equipped to deliver income, after inflation, and with less risk. Furthermore, it was capable in the simulation of leaving something behind for beneficiaries.
Conclusion and criticisms
The authors themselves quite justifiably say in their conclusion; ‘Despite the dominance of the internationally diversified, all-equity strategy in achieving retirement outcomes, investors and regulators may be uncomfortable with the risk of large intermediate drawdowns in stocks’[6].
This is a point well made, but we wonder whether good advice and a degree of ‘handholding’ when these drawdowns do occur would make sticking to the strategy more probable. In our experience, investors tend to be prepared to take more risk with their pension assets on the basis that they can’t access the capital for a significant period of time.
Furthermore, we wonder how to interpret the correct asset allocation for a UK investor. It seems to us that 33% in UK equities is a little higher than is perhaps justified given the relative weight of UK stock markets in a global context.
Since the October 2024 budget, the changes to pensions and the fact that pending the consultation process, these assets will be included in inheritance tax calculations, means advisers and their clients might need to reassess the existing investment strategy. We are very cognisant of what this might mean for the suitability of the investment strategy going forward but still sceptical of the appropriateness of lifecycle investing as everyone has different circumstances.
Riccardo Persona, CFA
[1] Anarkulova, Aizhan and Cederburg, Scott and O’Doherty, Michael S., Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice (December 06, 2024). Available at SSRN: https://ssrn.com/abstract=4590406 or http://dx.doi.org/10.2139/ssrn.4590406
[2] For a thorough summary of Lifecycle Investing see above Pg 7
[3] The authors assume an income of 4% per annum adjusted for inflation see note 1 above Pg 11
[4] This was a US study so international stocks in this context mean those outside America
[5] For example, 100 domestic stock, 100% Bonds and 100% cash.
[6] See note 1 above Pg 31
