There’s little life left in these once-stylish solutions.
Lifestyle funds were created with investor behaviours firmly in view. However, in light of (almost decade-old) changes to pensions legislation and advances in our understanding of what really helps investors, the particular view of investor behaviour they reflect now looks very dated.
In the pre-pension-freedoms world, lifestyle funds were a somewhat clunky but broadly defensible default option for someone who, when it came to their personal finances, knew their annuitisation date, but very little else.
Like most defaults, lifestyle funds have always solved some issues at the cost of creating others. The costs are still with us. The benefits have long since passed on.
Here are five reasons why it’s a wonder the funds themselves haven’t disappeared too.
- Lifestyle funds prioritise protection against an imaginary enemy – Forced annuitisation at a known date made protecting the value of investments at that date critical, to save the investor from the very real risk of selling their entire pension pot just after it had taken a precipitous plunge. Automatically reducing risk levels as the investment time horizon (and the investor’s risk capacity) approached zero was a wise move. However, without this risk, lifestyle funds are left looking like those Japanese soldiers who were still fighting WWII into the 1970s.
- Lifestyle funds are mismatched with almost every investor’s reality – The suitable level of risk to take with retirement assets is a function of several inputs, all of them personal – from future income and inheritances, to expenditure plans, to risks taken with (and willingness to part with) non-investible assets, and of course risk tolerance. Lifestyle funds instead determine risk levels largely (or solely) based on age; they’re using a pneumatic drill in place of a chisel. Dynamic changes in circumstances or preferences – such as shifts in income, unexpected expenses, or non-retirement objectives – are ignored entirely.
- Even when an investor purchases an annuity, lifestyle funds are inappropriate – Not all investors have to buy an annuity anymore, but many probably should, and indeed many do. However, staged annuitisation, where some (often the bulk of) retirement assets remain invested (potentially for many decades more) is generally more suitable than bringing all investment risk to an abrupt halt. The right level of risk to take with the proportion that remains invested requires a sophisticated, personalised, calculation, reflecting withdrawal rates and the investor’s actual risk capacity (see our White Paper for details of this).
- Lifestyle funds reduce risk inefficiently – Lifestyle funds often reduce risk in a clunky, linear fashion. They take too much risk off the table too early (when recovery is still possible) and too little too late (when it isn’t). In reality, risk capacity declines gradually at first as goals first faintly, and fuzzily, come into view, and accelerates only as the need to withdraw cash draws near (if indeed market growth hasn’t stopped risk capacity declining despite those withdrawals).
- Lifestyle funds are blind to individual investor behaviours – By providing default, predetermined, de-risking ‘glidepaths’ lifestyle funds promise to improve investor decisions (and tackle the discomfort and delays those decisions can inspire). However, lifestyle funds don’t so much improve decisions, as wave them away; they make them for you, based on almost no information about you. Were there no alternatives except staying in cash, or accidentally adopting a portfolio the risk of which becomes dangerously untethered from its original intention over the years, this could just about be considered a benefit, if you close one eye and squint with the other.
However, there are very real behavioural costs, and very real, much better, alternatives. The ‘set it and forget it’ lifestyle-fund approach fosters overconfidence that the portfolio will meet long-term goals without oversight. This encourages complacency, reducing investor engagement and preventing necessary adjustments to changes in financial circumstances, such as inheritance, job loss, or evolving retirement plans. In addition, lifestyle funds are heavily marketed and widely used, often leading investors to choose them out of familiarity or popularity, rather than suitability. These two points are especially true for pension funds, where lifestyle funds are frequently the default option. The typical employee tends not to want to engage with their pension fund choices, and is thus tempted to believe ‘default’ means ‘best for me’, thinking there’s much more careful, curated, personally meaningful selection going on behind the scenes than is actually the case.
This herd behaviour can result in poor alignment with personal financial needs – something that is inexcusable when there are ways to comprehensively account for investor circumstances and behaviours in a reliable and robust calculation of the suitable level of risk to take with retirement assets.
