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South African Journal of Economic and Management Sciences

versão On-line ISSN 2222-3436
versão impressa ISSN 1015-8812

S. Afr. j. econ. manag. sci. vol.20 no.1 Pretoria  2017 



Life cycle versus balanced funds: An emerging market perspective



Elbie Louw; Cornelis H. van Schalkwyk; Michelle Reyers

Department of Financial Management, University of Pretoria, South Africa





BACKGROUND: Inadequate retirement savings is an international challenge. Additionally, individuals are not cognisant of how asset allocation choices ultimately impact retirement savings. Life cycle and balanced funds are popular asset allocation strategies to save towards retirement. However, recent research is questioning the efficacy of life cycle funds that switch to lower risk asset classes as retirement approaches.
AIM: The purpose of this study is to compare the performance of life cycle funds with balanced funds to determine whether either dominates the other. The study compares balanced and life cycle funds with similar starting asset allocations as well as those where the starting asset allocations differ.
SETTING: The study has a South African focus and constructs funds using historical data for the main local asset classes; that is, equity, fixed income and cash, as well as a proxy for foreign equity covering the period 1986-2013.
METHOD: The study makes use of Monte Carlo simulations and bootstrap with replacement, and compares the simulated outcomes using stochastic dominance as decision-making criteria
RESULTS: The results indicate that life cycle funds fail to dominate balanced funds by first-order or almost stochastic dominance when funds have a similar starting asset allocation. It is noteworthy that there are instances where the opposite is true, that is, balanced funds dominate life cycle funds. These results highlight that while the life cycle funds provide more downside protection, they significantly supress the upside potential compared to balanced funds. When the starting asset allocations of the balanced and life cycle funds differ, the stochastic dominance results are inconsistent as to the efficacy of the life cycle fund strategies considered.
CONCLUSION: The study shows that whether one fund is likely to dominate the other is strongly dependent on the underlying asset allocation strategies of the funds. Additionally, the length of the glide path and the risk and return characteristics of the investable universe are also likely to influence the findings.




The potential inadequacy of accumulated retirement wealth is a global dilemma. The National Institute on Retirement Savings (2013) estimates that, should one consider formal retirement savings of households only, 92% of American households will fall short of their retirement targets while the Department for Work and Pensions (2012) estimates that 38% of the United Kingdom's workforce will not be adequately prepared for retirement.

Despite 5 143 retirement funds registered in South Africa which covers approximately 16 million members in 2015, it is estimated that only 6% to 10% of South Africans are saving sufficiently for retirement (Financial Services Board 2015a; Jones 2011; Old Mutual in Kemp 2005). Similar to other countries, the retirement funds in South Africa are predominantly defined contribution pension funds, which have significant implications for members who must participate in the investment decision-making process and who ultimately end up bearing the investment risks related to these decisions (Financial Services Board 2015a, 2015b; Levitan and Merton 2015). In a defined contribution retirement fund, the retirement benefit received by a participant upon retirement is not guaranteed and depends on the performance of financial markets. The individual bears the investment risk of the fund, and the plan often shifts a significant number of decisions such as the asset mix as well as how much to invest from the plan sponsor to the participant as is the case in a member-directed plan (Thaler and Benartzi 2007). In contrast, a defined benefit retirement fund refers to a fund for which the retirement benefit received by an individual upon retirement is guaranteed, irrespective of how financial markets perform, and determined by a formula which usually considers an individual's ending salary and years of service (Bodie, Marcus & Merton 1988). As this study focuses on asset allocation strategies, it is only applicable to defined contribution plans.

In terms of the allowable range of asset mixes, Regulation 28 of the Pension Funds Act dictates maximum exposures that a South African retirement fund may have to particular investable asset classes and, in certain instances, the acceptable selections within a particular asset class (National Treasury of South Africa 2011). Importantly, the higher return, higher risk equity asset class is restricted to a maximum of 75% of the overall asset allocation with the allocation to foreign asset classes limited to 25% (National Treasury of South Africa 2011). However, within the limits provided by Regulation 28 there are a wide variety of different asset mixes and asset allocation strategies, which members of defined contribution plans need to choose between which impact on their accumulated retirement wealth.

Many individuals are not cognisant of how the asset allocation of their chosen retirement savings vehicle and the consequential risk and return characteristics can influence the likelihood of reaching an accumulated retirement wealth target to sustain their post-retirement years or how different asset allocation strategies compare to one another. The importance of the asset allocation choice is further highlighted by Brinson, Hood and Beebower (1986) in that 93.6% of the variation of portfolio performance over time can be explained by the asset allocation. To help participants of defined contribution funds with some of the choices they have to make, plan sponsors often offer default options within the retirement fund to add some assistance to individuals with regard to appropriate investment choices (Levitan and Merton 2015). To this end, much research, using US data, has been devoted to comparing life cycle and balanced funds to determine, which approach provides a superior outcome (Basu, Byrne & Drew 2011; Estrada 2014; Lewis 2008a, 2008b, 2008c; Spitzer and Singh 2011).

There has been limited research regarding retirement savings decisions in South Africa and research that has been carried out has focused on understanding retirement adequacy goals and behavioural influences on retirement savings decisions (Reyers et al. 2015; Van Zyl and Van Zyl 2016). Only a limited number of studies have considered asset allocation strategies in a South African context with the focus varying from evaluating the impact of including foreign investments, comparing post-retirement investment choices, a comparison of default choices offered by retirement funds and the impact on portfolio optimisation based on an efficient frontier (De Villiers-Strydom and Krige 2014; Levitan and Merton 2015; Mjebeza 2016; Van Heerden and Koegelenberg 2013). Although valuable, none of these studies address the life cycle versus balanced fund question or apply the decision-making criteria stochastic dominance (SD). The objective of this study is to make use of the SD decision-making criteria to provide additional insights into the debate concerning life cycle versus balanced funds. In addition, the study adds to the literature by providing a developing world perspective by using South African data.


Life cycle versus balanced funds

While balanced or target risk funds maintain a constant asset allocation strategy throughout the investment horizon, Basu et al. (2011) describe life cycle or target date funds as funds where the assets are moved from higher risk to lower risk asset classes as the individual advances towards retirement in an attempt to preserve retirement ending wealth and offer downside protection (also see Branch and Qiu 2011; Lewis 2008b, 2008c; Spitzer and Singh 2011). Both mutual funds with a life cycle structure and pension fund life cycle funds have, therefore, become popular in the retirement fund offering because the individual does not have to make the asset allocation and switching decisions (with the intent to preserve capital) as the fund does so automatically - his or her only decision is choosing the appropriate life cycle fund given his or her expected retirement date (Basu and Drew 2009; Basu et al. 2011; Estrada 2014; Lewis 2008a, 2008b, 2008c; Spitzer and Singh 2008, 2011).

Much of the body of knowledge is devoted to consider how different balanced fund asset allocation strategies and life cycle fund asset allocation strategies fair as well as to critically compare the efficacy of traditional life cycle versus balanced funds. Importantly, Estrada (2014) highlights that the debates on the most optimal asset allocation strategy may be nestled in how risk is defined. Some may view a low-risk fund as a stable investment with little adverse shocks while an alternative view may be that a low-risk fund is the fund, which provides the highest mean accumulated ending wealth (Lewis 2008c; Shiller 2006). Should 'risk' be interpreted as a greater range exhibited by the outcomes, the balanced funds would be a riskier choice.

Research specifically related to life cycle funds carried out by Lewis (2008b) focuses on the replacement ratio that can be achieved by different life cycle strategies namely a conservative, moderate and aggressive strategy and includes the interquartile range as an indication of the risk of each strategy. The median replacement ratio for each strategy is 0.38, 0.36 and 0.33, respectively; however, the interquartile range of the replacement ratio for each portfolio offers valuable insights. For the aggressive portfolio, the range is 0.30 to 0.52, for the moderate portfolio 0.29 to 0.46 and for the conservative portfolio 0.27 to 0.41. The results highlight the issue of how an individual views retirement wealth risk; if shortfall risk during retirement is perceived as being a greater risk, more aggressive strategies with higher allocations to equity might be preferable where the shortfall refers to accumulating less wealth than what was required at retirement.

In Lewis (2008a), the focus shifts to shortfall risk in determining the efficacy of life cycle fund strategies. He acknowledges that the intent of life cycle funds is to lower the likelihood of potential losses by decreasing the allocation to risky assets as retirement approaches. The three life cycle funds modelled exhibit a 34.7% (aggressive), 43.8% (moderate) and 58.6% (conservative) probability of shortfall for an income replacement ratio of 0 to 0.5. Hence an individual who invests in the aggressive portfolio and pursues an income replacement ratio of 0.5 has a 34.7% probability of shortfall. Based on this approach, a higher allocation to low-risk asset classes may not be optimal despite the lower short-term volatility of the portfolio.

The research of Schleef and Eisinger (2007) compares different life cycle and balanced fund strategies and the chances of meeting a retirement target. The researchers conclude that strategies weighted towards equities still have a better chance of achieving the retirement target and that for all the simulated portfolios (life cycle and balance funds) there is more than a 50% chance of failing to meet the retirement target. Balanced funds with an asset allocation to equities of 70% or more are superior to all other portfolios, including an aggressive life cycle portfolio, in achieving the retirement target; the 100% equity portfolio has only a 39% chance of not meeting the target (Schleef and Eisinger 2007). Byrne et al. (2006) follow suit by comparing how a balanced fund (60% equity, 40% bonds) and a life cycle fund (100% equity minus the individual's age over the investment horizon) impact accumulated retirement ending wealth. The life cycle fund offers a higher mean replacement ratio irrespective of the investment horizon. In contrast, the results of Spitzer and Singh (2011) indicated that neither of the life cycle portfolios modelled outperformed a balanced portfolio with an allocation to equities of equal to or greater than 80%, and all the models exhibited right-skewness (the mean exceeding the median) similar to the findings of Pfau (2010). Importantly, Spitzer and Singh (2011) focus on achieving the highest mean ending wealth and do not consider the range of possible outcomes or the risk exhibited by each strategy. The studies highlight that the beginning and ending equity allocations over the investment horizon along with how aggressive the glide path is, are important factors which determine the success of a life cycle strategy. A valuable conclusion drawn by Basu and Drew (2009) is that life cycle strategies that commence with a glide path early in the investment horizon are better at protecting downside risk. There also seems to be a diminishing risk reduction benefit for life cycle strategies that defer switching to more conservative asset classes.

Lewis (2008c) also compared balanced funds with life cycle funds [similar to Spitzer and Singh (2011)] using similar life cycle strategies as in his previous research. Focusing on the proportion of final salary that could be obtained from the accumulated retirement wealth, the aggressive portfolio exhibits the highest standard deviation and widest range of proportion of final salary with the conservative portfolio exhibiting the lowest risk (standard deviation and range). Lewis (2008c) subsequently infers the average asset allocation to equity within each life cycle portfolio and simulates three comparable balanced funds. The results reveal the following: The average percentage of retirement salary which could be achieved by each of the resulting three portfolios is consistently higher for the balanced funds (Lewis 2008c). Furthermore, the kurtosis of the life cycle funds is consistently slightly higher than that of the comparable balanced funds (Lewis 2008c).

Pfau (2010) also makes a strong case in support of life cycle funds by focusing on the risk-return trade-off between more aggressive balanced funds and the protection offered by life cycle funds. His research introduces a utility function that captures the risk aversion of the individual and how this may alter one's interpretation of which strategy is optimal. Without considering investor utility, the life cycle strategies modelled by Pfau (2010) slightly underperform the balanced fund strategies with a similar average equity exposure.

Basu et al. (2011) introduced an innovative alternative to the traditional life cycle fund; the dynamic approach proposed considers the retirement target and the asset class returns achieved to date and only switches to lower risk asset classes on the condition that the retirement target may realistically be achieved based on the accumulated wealth at every stage of switching, therefore, considering the impact of past market performance and future return expectations. Basu et al. (2011) contend that although the traditional life cycle strategy may be appropriate to protect the downside risk of the portfolio closer to retirement, it may fail to realise the retirement wealth target.

The results of Basu et al. (2011) indicate that the dynamic life cycle strategies seem superior to traditional life cycle funds, irrespective of how long the glide path is. It also offers better downside protection and mean accumulated wealth compared with a balanced fund. Likewise, the higher the allocation to equities in a balanced fund, the better the mean wealth accumulation. The riskiness of the strategy as measured by range, distribution and standard deviation increases with the equity allocation.

The literature presents life cycle funds that start and end with varying exposures to equity and diverse periods over which the glide path is implemented. These factors make it difficult to generalise about the performance of these funds. However, the majority of literature indicates that, generally, a balanced fund with an average asset allocation over the investment horizon, which is similar to that of a life cycle counterpart, offers a higher mean retirement accumulation and wider range, distribution and standard deviation (Lewis 2008c). This general finding has been challenged by Pang and Warshawsky (2011), who acknowledged that balanced funds exhibited a wider range, distribution and standard deviation but indicated that, in their research, the mean accumulated ending wealth for balanced and life cycle funds was quite similar.


Research method

Life cycle and balanced fund models

Four balanced funds (BF) and life cycle funds (LC) each are considered. The four balanced funds (BF1 to BF4) each have a unique asset allocation strategy as detailed in Table 1. In the case of the life cycle funds, two contrasting starting asset allocations are considered (LC1 vs. LC2), as well as different glide paths over 10 and 5 years, respectively (contrast LC1 (10) with LC1 (5)). In all instances, the funds modelled comply with the requirements of Regulation 28 of the Pension Fund Act. The asset allocations and glide paths (where applicable) for all funds modelled are shown in Table 1.

In comparing traditional LC funds with BF, the research considers a South African resident that saves for retirement from age 25 to 65 (a 40-year investment horizon) and earns a starting salary of R673 101 (South African Rand). The individual's salary annually increases at a rate of inflation of 4.5%. Throughout the pre-retirement investment horizon, the individual contributes 15% of the annual salary to a retirement fund while the contributions are made at the end of each month. This implies that the individual makes 480 monthly contributions. Furthermore, the individual is assumed to be in the workforce for the full 40-year investment horizon.

All the funds modelled are rebalanced