Asset allocation as you age
How age changes investing preferences.
Vanguard's latest edition of How Australia Saves - a report which takes a deep dive into how Australians are managing their superannuation savings - confirmed that the vast majority (87%) of super members have their retirement savings sitting in the default options of their superannuation fund.
This reliance on default funds is both a strength and weakness of the Australian super system.
A strength is that the same research shows that in most cases, the default option outperformed those, without professional planning help, who built their own asset allocations based on the available investment options on the menu in their super fund. And importantly, those invested in the default options had less risk baked into their portfolios than the individual portfolios.
A perceived weakness with both mandatory contributions and default options, is that they have the effect of driving disengagement by Australians with their superannuation.
However not everyone in the default options is disengaged – a number certainly will have decided that the default option's asset allocation is right for them.
But an interesting question, and potentially a greater weakness of the system, is whether the asset allocation of a typical default fund suits members of any age.
Age is a pretty powerful filter for investment decision-making. Financial advisers sometimes 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.
If you consider two super 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 in their investment portfolio – the same percentage exposure to both growth (equities /property) and fixed income (bonds) and cash assets.
Yet our 25-year-old may have their money invested for the next 70 years. Our near retiree realistically has a time horizon of more like 20-30 years.
In addition to their age difference, their ability to recover from severe market shocks, like a global financial crisis, is also very different.
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 40 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. Technical folks call this sequencing risk.
Each of these members could 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 given what we know about disengagement or inertia in superannuation, most people do not do that.
A new breed
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.
In the US, such products called 'target-date' or lifecycle funds have become a dominant choice for default portfolios.
Vanguard in the US is a major provider of investments and record keeping services to the retirement industry, and has recorded a 50 per cent rise in the use of target-date funds over the ten years between 2007 and 2017. Now about three quarters of all retirement savers in the US use these types of funds.
Target date funds are not all built the same. Vanguard's approach is to segment investors into four phases, the first of which caters for younger investors (under 40) where a higher allocation to equities – around 90 per cent - is used.
The second phase moves the asset allocation to a 50/50 split between growth and income investments for people aged 41-65 – an asset allocation that is very reflective of many of the balanced default funds available to Australian super members.
Phase three is when investors are in the early years of retirement and again the asset allocation to riskier assets is reduced, while the fourth phase is for members who are in the later stages of retirement, with the portfolio keeping just a modest exposure to equities within the portfolio.
Back to basics
If you take the concepts which a target date fund presents in terms of asset allocation principles, they are simply providing an automated way to dial back market risk as an investor ages, in addition to recognising the increasing importance of capital preservation as you age.
The aim is avoid extreme asset allocation decisions – either too aggressive or overly conservative – and avoid the impact of poor portfolio construction due to inadequate diversification.
These are sound, fundamental principles which can be leveraged by anyone considering their appropriate asset allocation to complement the goals they are saving towards.
Your asset allocation - how you allocate money to each asset class - is one of the most important decisions faced when constructing an investment portfolio – and there is a wealth of evidence showing it has the biggest influence out of all investment decisions on the performance of your investment.
This article was first published in the ASX Investor Update newsletter on 12 June 2019
Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
18 June 2019