Why Life Cycle Funds are Second Best

Life Cycle Funds (LCFs) are seen as the ideal solution for pension planning. Unfortunately they aren't..... They're Second Best....

Pension Funds solutions (PFs), are far more superior to LCFs, as will be shown in this blog with regard to the performance of a pension plan.

Life Cycle

A Life Cycle approach presumes that, while your young and still have a long time before retirement, you can risk to invest more than an average pension fund in risky assets like stocks, with an assumed higher long term return than bonds,

As you come closer to the retirement age, you'll have to be more careful and decrease your stock portfolio incrementally to zero in favor of (assumed) more solid fixed income asset classes like government bonds.

A well known classic life cycle investment scheme is "100-Age", where the investment in stocks depends on your age. Percentage stocks = 100 -  actual age.
E.g.: If you're 30 years old, your portfolio consists of 70% stocks and 30% bonds.

Here's what the average return of a life cycle '100-Age' investment looks like when you start your pension plan at the age of 30 and assume a long term 7% average yearly return on stocks and 4% on bonds.
The return of this life cycle fund is compared to a pension fund with continuously 50% in stocks.

Key question is however, is the younger generation also risk minded and the older generation risk averse?

As often in life and also in this case, what would be logical to expect, turns out just to be a little bit more complicated in practice....

Misunderstanding:Younger people have a high risk attitude
Research by Bonsang (et al.; 2011) of the University of Maastricht and Netspar shows that on average 25% of the 50+ generation is willing to take risk.

 The research report shows evidence  that  the  change  in  risk  attitude  at  older age  is driven by 'cognitive decline'.  About 40 to 50% of the change in risk attitude can be attributed to cognitive aging.

Unfortunately other recent research also shows that only 30% of people under age 35 say they're willing to take substantial or above-average risks in their portfolios (source:Investment Company Institute).

This implies that -  although they would theoretically be better of on the long run - younger people will certainly not put all their eggs in one basket, by investing all or most of their money in stocks.

Pension Fund Investment Horizon
In contrast to individual pension member investors, a pension fund has a long term perspective of more than 20-50 years as new members (employees) keep joining the pension fund in the future. Therefore a pension fund can keep its strategic allocation in stocks relatively constant over time instead of decreasing it.

This implies that a pension fund on the long term has an advantage (longer horizon) above a life cycle fund. Let's try to find the order of magnitude of this difference.


Comparing a Life Cycle fund with a Pension Fund
First of all, we have to take into account that younger people will not over invest in stocks.

Let's assume:

• A 30 year old 'pension plan starter', retiring at age 65
• Contribution level   (€, $, £, ¥,): 1000 a year
• A long term 7% average yearly return on stocks and 4% on bonds
• Life Cycle Investment scheme
  A modest 50% stocks, with a yearly 2% decrease as  from age 50
• Pension Fund Investment Scheme
  A constant 50% investment in stocks (and 50% in bonds)
• Inflation 3%, Pension and Contribution indexation: 3%

 This leads to the next yearly return of these portfolios, as follows:

To find out the overall difference in return between LCF en PFS, we calculate the Return on Investments (ROI) of both investment schemes with help of the:

Pension Calculator

The outcome looks like this:

As you can see the ROI outcomes (left axis) on the investments (yearly contribution) from 'dying age' 65 to age 69 are negative as the cumulative payed pensions (compared to your contribution) didn't (yet) result in a positive balance. Or to put it in another way, if you die between age 65 and 69, you died too early to have a positive return on your paid contribution.

Overperformance
The right axis shows the difference between the LC ROIs and the PF ROIs.
As you may notice,  the pension fund has a structural yearly overperformance of more than 0.3%  and an average overperformance between 0.4% and 0.5% per year.

Overperformance expressed in pension benefits
Expressed in terms of yearly pensions the differences are as follows:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	11673	83%
LC '100-Age'	12304	93%
PF 50% stocks	13172	100%

For a 40 year old pension plan starter, the differences are:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	5359	82%
LC '100-Age'	5578	92%
PF 50% stocks	6040	100%

Conclusion

Investing in life cycle funds ends up in a 7% to 18% lower pension than investing in a pension fund with 50% investment in stocks.


So..., Be wise and choose a pension fund for your investment if you can!


Aftermath
Of course, every pension vehicle has its pros and cons ... So do Life Cycle AND Pension Funds.....

Related Links/Sources
- CNNMoney:The young and the riskless shun the market (2011)
- Cognitive Aging and Risk Attitude (2011)
- America’s Comm. to Ret.Security: Investor Attitudes and Action (2012) 
-  “Saving/investing over the life cycle and the role of pension funds” (2007)
- Excel Pension Calculator Blog
- Benny AND Boone Comic Strips
- Study: Public employee pensions a bargain (2011)

Pension Fund Weigh House

Investment Benchmarking of Pension Funds has been made extremely difficult.

Just ask your Pension Fund's actuary whether your Pension Fund has achieved a 'market conform investment performance'... For sure you'll get a dazzling multiform and relative answer. It's all about 'market indexes' (stock and bond indexes), risk appetites, asset mixes, derivatives, uncertainty and lots of other interesting complex stuff that underpins the fact that the final answer to this simple question is nuanced, complex and relative.

A simple question
Ahead of all this growing complexity and 'levels of detail', a first key question has to be answered by every Pension Fund:

Was it worth setting up a complex multi fund investment plan instead of simply investing in 10-Years Government (Treasury) Bonds over an arbitrary period of (at least) the last 10 years?


Even this simple question, will probably not lead to a simply answer from your fund's investment manager or actuary.

Pension Fund Weigh House Help
This is where the help of the 'Pension Fund Weigh House' comes in...

Just look up the yearly return over the last ten years in your Pension Fund's annual report. Next, do the test at 'Pension Fund Weigh House'  (PFWH) and see for yourself whether your Pension Fund has  performed better than the simple benchmark: 10-Y Bonds.

 

Did your Pension Fund perform better than Bonds? (the compound mean over the last 10 years) Congratulations!
Was it worth the risk? Well..., just look at the Risk (Standard Deviation) or - even better - the Sharpe Ratio at different levels of possible 'Risk Free Rates' to find out. The Higher the Sharpe Ratio, the more it was worth to take the risk.

Market Value

To compare Bonds 'fair' with Market Value based Pension Fund performance, the yearly Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in January of a specific year are valued, and sold at the interest rate one year later.

Do it yourself

The standard example as presented on PFWH concerns the performance of the Dutch pension fund ABP, the third largest pension fund of the world. Answer the key question 'Was it worth?' for ABP for yourself.

ABP (Pfd-R) Performance 2001-2010

 

Go to PFWH and change the numbers and 'heads' in the application to fit the numbers of your own (pension) fund or change both columns (Bonds & PFD-R) to compare two pension funds .
Compare your pension fund to either  '10-Y Euro Government Bonds', '10-Y US Treasury Bonds' or the 'S&P 500 Index'.

From now on you may answer this extremely difficult question "How did my pension fund perform?" yourself in a  5 minute weigh house test.

Have (professional) fun!

Dutch Pension Muppet Show

There's a lot of fuzz about the performance of the largest (€ 246 billion assets) Dutch Pension Funds ABP and the somewhat smaller (€ 91 billion) PFZW (former PGGM). According the Dutch television program Zembla and Bureau Bosch Asset Consultants, Dutch pension funds would have consistently underperformed.

ABP commented: "The yearly return of 7.1% on average since 1993 is much higher than returns on government bonds would have been and is in part thanks to our equity investments."

PFZW overshoots ABP wit the comment: "PFZW's calculations show a return of 8.4% on average during the past 20 years which is much higher than the 10-year Dutch government bonds of 5.3% on average during the same period."

Great statements, but who's right?

Performance Test
Let's quickly "do the proof" by comparing (benchmarking) the 'modest' yearly performance of ABP with the yearly performance of 10 year Government Euro Bond Yield Benchmark as provided by the ECB.

Both pension funds are not limited to  the Dutch market, therefore  performance is not related to Dutch Government Bonds, but to 10-Y Euro Government Bonds.

As the yearly performance of ABP in a particular year is in fact a kind of 'compound performance' of the years before, it's more realistic to relate ABP's (yearly) performance to the 10-years moving average of 10-Y Euro Bonds.  

What becomes clear from is that ABP's volatility overshadows the 10-year Bond's volatility by far. As a consequence ABP's out-performance should be significant.

Let's test this by looking at the YTD (Year To Date) performance of ABP on the long run:

The average performance of ABP 1993-2010 indeed turns out exactly 7.1% as published, but hardly outperforms the 10-year Euro Bonds Moving average of 6.8%.

0.3% '18-years out-performance' (OP-18) for such a high volatility is strongly discussable. The long term out-performance 1994-2010 (OP-17) was 0.0%. The out-performances of shorter periods (OP-[18-x]) are not stable and strongly swap from positive to negative.

Benchmarking Pension funds performance with Euro Bonds 0f 20 years or longer would be even more adequate and in line with the duration of pension fund's liabilities. Taken into account that 20 year Bonds on average score a 0.25% à 1.00% higher return than 10 year Bonds, it can be concluded that Dutch pension funds on average do not out-perform Government Bonds. Not to mention the influence of the yearly investment-costs of at least 0.2% on the returns.....

Pension Fund PFZW

Pension Fund PFZW is completely lost on their non-transparent and backwards changing performance of 8.4% over the last 20 years.

From their annual (inconsistent) accounts it can be concluded that their 2001-2010 performance came down to 4,8%. This performance is exactly the same as the performance op ABP in that period and underperforms the moving average 10-years Euro Bonds with 0.7% !!!

Conclusion

It's clear that pension funds don't convince in the outperformance of Government Bonds and that the pension industry is in desperate need for an impartial benchmark with regard to out or underperformance of Bonds.

The comments from ABP and PFZW, Boenders and Cocken are like 'shooting from the hip' and must be qualified as highly unprofessional.

Dutch pension fund members are watching an extra edition of the Muppet show. Who's gonna stop this pension media madness and bring some order in the pension room?


Related Links and Sources:

- Source: 10 year Government Euro Bond Yield Benchmark
- 'grave miscalculations' in Zembla (Boender aand Kocken
- Watch: Zembla 
- Download: Spreadsheet with calculations as presented
- IPE: Heavyweights ABP, PFZW come out swinging against Zembla
- Bloomberg: 10-year, - -  30-year performance Gv. Bonds

Price of Greed and Fear

Despite of all our knowledge, training and experience we sometimes decide to follow our heart instead of our head.
What's wrong with that?

Answer:
Nothing, as long as your decisions are not based on greed and fear

Illustration: We all know.....

I. How to advice on getting a better reward/risk ratio.
Modern Portfolio management (MPT) helps us.

Risk/return trade-off between bonds and stocks1980-2004 (AAII)
Bonds: 60% 5-year Treasury Notes+40% LT Treasury Bonds
Stocks:(S&P 500)

II. The performance/time model of stocks

III. Asset allocation is key behind portfolio returns
So it's not about Market Timing!

Moreover Market Timing is a dangerous game as research firm DALBAR showed.

Although the S&P 500® 1988-2007 Index had an annualized return of 12%, the average equity fund investor (in equity mutual funds) only generated a 5% return and market timers, who tried to outsmart the market by timing their inflows and outflows, generated an annualized loss of 1%.

Market Strong ... Investors Wrong

*Measures returns of investors in equity mutual funds. Source: Bureau of Labor Statistics, DALBAR

Greed and Fear
When the asset strategy has been chosen and implemented, it comes down to strong nerves, to hold this strategy.

But nothing human is strange to us. Who can resist the pressure of shareholders, advisors or analysts to question the current strategy after 2 or 3 years of extremely high (or low) stock returns?

In straightening out and defending your policy, stakeholders and advisors will often argue that you're a rearview mirror actuary or board member. They'll stress that the actual situation is not comparable with any situation in the past.

However, always keep in mind the words of Sir John Templeton (1912-2008) :

The four most expensive words in the English language are
'This time it's different'

So how successful are you, in cashing in on your emotions an withstanding pressure?

Still, if you nevertheless give in and are going to change your bond/stock ratio based on fear, greed or hype, all bets are off.

Example



As is clear form the example above, when your strategy is vulnerable to heart cries, you'll end up in the famous Pork Cycle , which - in this case - leads to a return level beneath that of risk free assets. The price of Greed and Fear!

Lesson
When you've set your assets according your chosen asset strategy, only change this strategy when the underlying long term asset-modeling parameters substantially change. In every other case, don't decide on basis of 'heart over head'.

Define and allocate equity (as security) for an 'up front' defined period of time in wich you're willing to except lower or even a defined maximum negative performance. Agree this strategy up front with the supervisory board and national Supervisors.

Sources: MyMoneyBlog , Schwab, DALBAR

DB plans outperforme DC plans by 1%

Watson Wyatt has been comparing rates of return between defined benefit
(DB) and defined contribution (DC) plans for more than 10 years.¹
This most recent comparison finds that between 1995 and 2006, DB plans
outperformed DC plans by an average of 1 percent per year.



Asset-Weighted Median Rates of Returns
DB and 401(k) Plans — 1995-2006

Year	Number of sponsors	DB plan	401(k) plan	Difference
2006	914	12.90%	11.34%	1.56%
2005	2, 584	7.74%	6.69%	1.05%
2004	2,583	11.81%	9.80%	2.01%
2003	2,514	21.35%	19.68%	1.67%
2002	2,085	-8.56%	-10.93%	2.37%
2001	2,239	-3.78%	-6.07%	2.29%
2000	2,058	-0.01%	-2.76%	2.75%
1999	1,472	13.46%	14.41%	-0.95%
1998	2,958	14.25%	15.29%	-1.04%
1997	2,931	18.82%	19.73%	-0.91%
1996	3,034	14.53%	14.10%	0.43%
1995	3,063	21.10%	19.20%	1.90%
Average		10.30%	9.21%	1.09%

Source