Asset Allocation Through The Ages

The majority of members of super funds have their retirement savings in the default or MySuper options. This is both a strength and weakness of the Australian superannuation system.

The weakness manifests itself because with mandatory contributions and default options there are low levels of member engagement with their retirement savings.

That is not to say that everyone in the default options is disengaged – a number certainly will have decided that the default option’s asset allocation suits them just fine.

The interesting question is whether the asset allocation of a typical default fund suits members at any age.

Age is clearly a powerful filter for investment decision-making. Financial advisers are prone to say that if they had to build a financial plan based only on one piece of information that your age would be that critical data point.

So consider two super fund members. One is 25 years old and has started their first full-time job, the other has just celebrated their 64th birthday and is planning their life after full-time work about a year from now.

Both are invested in the same fund’s default balanced option and therefore have exactly the same asset allocation for their super savings.

Yet our 25-year-old has an investment horizon that could feasibly stretch over 70 years. Our near retiree realistically has a time horizon in the 20-30 year range.

And along with their age difference is their ability to recover from severe market shocks like a global financial crisis. For the 25-year-old a GFC like event would barely show up as a blip on their fund’s performance chart as they approach retirement in 50 years time. For the 64-year-old the consequences and impact of a GFC event on their retirement lifestyle could be much more immediate and dramatic as they enter the drawdown years.

Now each person can choose to move away from the default by opting for one of the other risk-based portfolios – typically ranging from conservative or stable to high growth – and align their asset allocation more closely with age and therefore risk profile.

But human nature being what it is most people do not do that.

A new generation of default options are emerging in the Australian market where the asset allocation is driven by the age of the member rather than targeting a certain level of risk for the portfolio investment mix.

So-called target-date or lifecycle funds are increasingly becoming the dominant choice for default portfolios in markets like the US 401(k) system which is comparable to our own defined contribution superannuation system.

Vanguard in the US is a major provider of 401(k) record-keeping and investment services and has seen the use of target-date funds rise from about 2% back in 2005 to about 40% in 2014 and forecasts that 63% of members in the 401(k) plans will be invested in them by 2019.

It must be said that the Australian system’s starting point of investing in default funds taking a balanced portfolio approach was much better than the US system where a money market or cash fund was a common default.

A number of different methodologies have been developed for the target-date approach. Vanguard’s approach is to segment investors into four distinct phases.

Phase 1 includes younger investors (under 40) where a higher allocation to equities – around 90 per cent – is used. Phase 2 sees the asset allocation move to a 50/50 split between growth and income investments for people aged 41-65 which is much more akin to current balanced defaults.

Phase 3 is when investors are in the early years of retirement and again the asset allocation to riskier assets is reduced, while phase 4 is when members are in the later stages of retirement although there remains a modest exposure to equities within the portfolio.

The target-date approach is simply providing an automatic approach to dialing down market risk as the member ages and recognising that capital preservation increases in importance as we get older and particularly after we have stopped full-time work.

Self-managed super fund trustees may question how relevant these types of default options are to them but the same challenges apply. The aim is avoid extreme asset allocation decisions – either too aggressive or overly conservative – and the impact of poor portfolio construction because of inadequate diversification.

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.