Dr Con Keating in Tayyabs
In the course of my recent work on value for money metrics, I have come across several schemes which apply life styling to older ages and many have argued that these strategies merit a benchmark which differs from the traditional 80/20 Equity-Debt construction.
The expression ‘life-styling’ refers to portfolios which progressively move their asset allocation away from equity to debt as the member’s age increases and retirement approaches. The objective is to minimise the volatility of the portfolio’s value at retirement, which of course, was previously the prime determinant of the member’s retirement income.
There are difficulties with creating benchmarks for ‘life-styling’ in that this practice applies at the level of the member’s allocation, not the overall consolidated fund. It is also far from clear why this strategy should be treated differently from any other strategy where comparison is made to the available investment opportunity set.
The process of moving progressively to higher bond allocations will carry with it the. prospect of a smaller ‘pot’ value at retirement than would be expected with the standard 80/20 portfolio. The question the becomes: is this lower pot value warranted by the risk avoided.
This may be investigated quantitively. I set up a simple model, where debt securities have an expected return of 4% and volatility of 10%, with equities having an expected return of 7% and volatility of 20%. The correlation between them is 0.4. The returns distributions are assumed to be -Normal. The portfolio allocation is then modified from an initial 80/20 to all bond in steps of 5% until is reaches 100% debt after 17 years.
At this time the expected value of the 80/20 benchmark is some 20.45% higher than the ‘life-styled fund. The likelihood of the 80/20 benchmark delivering a return below the ‘life-style’ expected value is 14.24% and the expected loss relative to that value is 7.63%. By contrast, the lifestyle fund has a 50% likelihood of a return below its expectation with a value of 6.74%. If we define risk as the product of the likelihood and magnitude of an event, then the risk of the ‘life-style’ strategy is 3.37% while that of the benchmark 80/20 portfolio is just 1.08%. It appears that in this instance ‘life-styling’ is a case of reckless prudence in risk management.
The loss events of the ‘life-styling’ and benchmark portfolios are not independent of one another; they have a degree of dependence by construction. 32.8% of the benchmark portfolio’s problematic returns will be associated with underperformance by the ‘life-style’ portfolio; a case of damned if you did or damned if you did not follow the strategy.
In the vast majority of outcomes, the pension saver is far better off invested in the 80/20 Benchmark; The ‘lifestyle’ portfolio only exceeds the expected value of the Benchmark 80/20 portfolio in 2.04% of circumstances.
Of course, this is one simple illustration and we might vary any or all of the model assumptions, the expected returns on debt or equity, their correlations or the speed at which ‘life-styling’ is introduced. We might even introduce more complex rules, path-dependent strategies, such as moving to bonds only after a strong equity return, but these will all bring with them only variations in degree of the problem illustrated here.
If we add to this concerns that we may currently be in a debt bubble induced by monetary and quantitative easing, with the implications of that for future debt returns and volatility, ‘life-styling’ appears to be far from conservative and indeed unlikely to deliver the benefits usually claimed for it.