Dynamic Lifecycle Strategies for Target DateRetirement Funds

Abstract

Lifecycle funds offered to retirement plan participants gradually reduce their exposure to stocks as they approach the target date of retirement. We show that such deterministic switching rules produce inferior wealth outcomes for the investor compared to strategies that dynamically alter the allocation between growth and conservative assets based on cumulative portfolio performance relative to a set target. The dynamic allocation strategies proposed in this paper exhibit almost stochastic dominance (ASD) over strategies that switch assets unidirectionally without consideration of portfolio performance.

Life cycle versus balanced funds: An emerging market perspective

“…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.…”

“…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 2008bLewis , 2008cSpitzer 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 2008aLewis , 2008bLewis , 2008cSingh 2008, 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 2008aLewis , 2008bLewis , 2008cSingh 2008, 2011).…”

“…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.…”

“…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 2008aLewis , 2008bLewis , 2008cSpitzer and Singh 2011).…”