Are Life-Cycle Funds Too Risky and Expensive?

They work for Wall Street, but do they work for us?

Photo by Austin Hervias on Unsplash

Economics Matters — Blog/Podcast/Financial Riddler/MaxiFi Puzzler

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Who Benefits from Lifecycle Funds? Workers or Wall Street?

The 2006 Pension Protection Act (PPA) allowed lifecycle, aka target-date funds, to serve as a “qualified default investment alternative,” permitting employers to choose them as default investment options for their 401(k), 403(b), and similar retirement plans. For young workers, lifecycle funds invest 85% or more of plan contributions in stocks with the remaining 15% or less allocated to bonds. Over time the equity share falls to roughly 60% by age 50 and roughly 25% by age 65.

Does lifecycle investing make sense for anyone, let alone everyone?

The 2022 Secure 2.0 Act required employers to auto-enroll workers in their retirement plans. Thus, if young Jane starts, today, to work for ABC, Inc., which has a 401(k), she’ll not only be auto enrolled, but also auto invested in a lifecycle fund — the default investment for virtually all employer retirement plans.

Jane will also be auto billed for the opportunity to have, as I’ll argue and demonstrate, her saving potentially very badly misallocated. The typical lifecycle fund charges an outrageous 25 to 100 basis points for automatically adjusting participants’ portfolios as they age — a task that is fully automated. Most workers have no idea they are being charged this fee since it simply shows up as a lower return on their investments.

Fees aside, why isn’t an age-invariant, 50% stock — 50% bond allocation set as the default investment? Indeed, why aren’t 30-year inflation-indexed Treasury bonds set as the default? As I’ll argue below, long-term TIPS — Treasury inflation Indexed Securities — are the fiduciarily proper, safety-first, investment default.

Btw, 50-50, stock-bond investing is what my co-author of three books, Scott Burns, calls Couch Potato Investing. Scott’s fabulous new book, Invest Like a Couch Potato, will be published by Wiley in March!

The Phony “Stocks Are Safe In the Long Run” Argument for Life-Cycle Investing

Why should young people be invested more heavily in stocks than in bonds? One fallacious argument is that stocks are safe in the long run. Yes, stocks (the S&P 500 since 1925) have a high average annual real return — roughly 7% above inflation. But the standard deviation around this return is close to 20%. And that’s just the average variation. In 8 of the past 100 years, the S&P dropped by over 20 percent. The three largest annual declines were negative 37% in 1937, negative 40% in 2008, and negative 45% in 1931. In 12 of the past 100 years, the S&P rose by over 20 percent. The three largest annual increases were 51% in 1933, 49% in 1954, and 33% in 1975.

Apart from trend, financial returns are essentially random walks. This means that next year’s real return on the S&P is anyone’s guess. The reason is simple. Asset valuations are based on available information. Hence, changes in valuations reflect new information, i.e., news. And news is, of course, unpredictable. Otherwise it wouldn’t be news.

Clearly, the market is a wild ride on an annual basis. It’s also a wild ride on a long-term basis. If we take each of the past 100 years of annual real returns on the S&P as a potential independent random draw and form cumulative 30-year returns by drawing from this distribution, almost 5% of the cumulative 30-year returns will be negative. (There are 99^30 such cumulative returns to consider. Perplexity AI examined 10,000 in its Monte Carlo simulation.) The worst cumulative 30-year real return was -32%. On average, the negative 30-year cumulative real returns averaged -14%.

Hence, when your broker tells you “Stocks are safe in the long run.” say, “Great.” Then ask them to guarantee you’ll at least get your money back. Watch as their face turns red.

In this 1994 paper, Boston University Finance Professor, Emeritus, Zvi Bodie, points out that if investing in common stocks were less risky the longer an investor plans to hold them, the cost of insuring against earning less than the risk-free rate of interest would decline as the length of the investment horizon increases. But, as Bodie demonstrates, the opposite is true.

In short, if you are 30 and stocking away your savings just in stock and counting on retiring at age 60 based on an enormous stash, think again. There’s a one in twenty chance you’ll have substantially fewer hot dogs than you saved if we measure real purchasing power in the form of hot dogs whose hypothetical price stays even with inflation.

Consider, as an alternative, investing for 30 years in 30-year TIPS. At today’s current 2.45 percent real yield, a $1000 investment will more than double your money when you cash out three decades from now. (This ignores taxes, which can be particularly nasty if you are holding TIPS or, indeed, plain vanilla nominal bonds outside of retirement accounts.) On average, 30-year TIPS have yielded 2.32 percent real at issue.

Legitimate Arguments for Lifecycle Investing

Papers by Zvi Bodie, Robert Merton, and William Samuelson, Francisco Gomes, myself, and Luis Viceira, and others point out that the ability of workers to adjust their labor supply in response to adverse stock market returns makes investing in stocks more attractive for the young. Moreover, as workers age, they have fewer future years left during which they can earn more to make up for bad stock returns. As a result, they should lower their stock exposure as they age. This, then, is a sensible argument for defaulting younger workers disproportionately into stock and having the equity share of the portfolio decline through time.

Another legit argument is conveyed in this book — Are You a Stock or a Bond, by Moshe Milevsky. Milevsky (see our podcast) points out that, to the extent your labor earnings are unrelated to the performance of the stock market, those earnings are, effectively, holdings of bonds. Since this is the case for most workers and since workers are younger than retirees, younger people should hold more stock relative to bonds than older workers.

This said, most workers may not have the option of earning more money when their stocks tank. As for younger folk being bonds, this rings true for those with established jobs, i.e., for those in their middle ages. When you’re young, your wages are generally low. Indeed, they may be lower than the safe, bond-like Social Security benefits you’ll receive in retirement. Wages typically peak around age 45. This suggests the portfolio share allocated to stock should rise through middle age and then decline as you approach retirement. Reinforcing this is the uncertainty, when young, of your future lifetime labor earnings. Other things equal, this extra risk, even if uncorrelated with the market, will militate toward a smaller position in stock.

After retirement? If Social Security benefits are higher than your earnings were when you were young, your stock portfolio share during retirement should, other things equal, be higher than when you started working. But Social Security can induce stock holding through a different channel. Suppose you choose to spend more in your early years of retirement, taking the chance that you’ll not make it to your maximum age of life. In this case, you’ll potentially end up late in life living solely or primarily off of Social Security. And leading up to this point, your assets will decline relative to your unchanged annual Social Security benefits. This will, year after year, make you, figuratively speaking, more of a bond than a stock. Consequently, with each passing year in retirement you should invest an ever larger share of your declining assets in stock. (My paper with Gomes and Viceira show this result theoretically and computationally.) That’s not something lifecycle funds do. Their share of stock remains at roughly 25 percent for what may be 40 years of retirement!

Taxes, mortgages, and housing costs also enter into the optimal portfolio decision. Each involves fixed payments, which mean each effectively constitutes negative bond holdings. The larger your holdings of negative bonds — the more you are short bonds, the more you’ll want to invest positively in bonds to diversify your overall resources.

There are clear age patterns to all three of these variables. Obviously, retirees have no labor income subject to taxation. In addition, most retirees have paid off their mortgage and many have downsized their homes. On the other hand, older retirees may face high taxes due to non-Roth, retirement-account withdrawals, Medicare Part B (IRMAA) premiums, taxes on Social Security benefits, and taxes on regular asset income. Hence, taxes may be higher in retirement than during one’s working years.

Mortgages loom larger for younger and middle aged households. Investing in stocks while you have a significant mortgage is fundamentally no different from borrowing to play the market. And having to make fixed property tax, homeowners insurance, and maintenance expenses on your home is fundamentally no different from having to make fixed mortgage payments. All off-the-top/fixed expenses effectively represent leverage that should lead you to limit your stock holdings.

Two other major factors come into play in considering optimal asset allocation. The first is the taxation of returns on stock. Depending on the extent of profit retention (retained earnings), the positive return on your stocks will be immediately taxed. In contrast, deductible losses are limited with losses above specified limits subject to carry-forward provisions. Thus, the tax system can differentially reduce the upside risk to stock investing and make holding stock less attractive.

The other factor is your legacy preferences. Suppose you’ve reached retirement and have more than enough resources to cover your own discretionary spending needs. In this case, you are, effectively, investing on behalf of your children or your other heirs. If your children are, figuratively speaking, bonds (stocks), you may wish to invest relatively more in stock (bonds).

The Bottom Line — When It Comes to Optimal Investing, One Size Fits None

I’ve droned on here to make one thing clear — pigeonholing essentially all retirement plan participants into a single investment strategy makes no economic sense. Every household is different on a multitude of dimensions. And as I demonstrated in this column, seemingly minor differences in household circumstances, like whether you are about to purchase a house, whether your IRA is a Roth or a traditional account, and whether you face high fixed expenses, can dramatically impact your optimal asset allocation.

But to make this discussion concrete, I’ll now use my company’s MaxiFi Planner software to demonstrate the potential economic cost of holding a lifecycle fund compared to a 50-50 balanced portfolio. This is not to advocate the balanced portfolio as the appropriate default investment. In my view, employers have no business telling their employees either how much they can invest on a tax-subsidized basis or in what assets they can or should invest. Employers aren’t our parents, our siblings, our friends, or our financial advisors.

This said, whether they like it or not, employers are implicit fiduciaries when it comes to making investment default decisions. If they take this responsibility seriously, they should consider making their default investment 30-year TIPS. This is the safest, long-term investment available. If workers want to change their investment allocation and invest at risk in stock, bonds, commodities, and other financial instruments, that’s their choice. But they should not be defaulted into holding stocks under the false pretense that stocks are safe in the long run and the highly questionable assumption that lifecycle funds match every worker’s investment needs.

Does Lifecycle Investing Beat Balanced Investing? A MaxiFi Comparison

MaxiFi does Living Standard Monte Carlo® analysis in maximizing your expected lifetime utility. I.e., it considers, via Monte Carlo simulations, all the annual living-standard paths you’ll potentially experience if you invest more or less aggressively through time. To be precise, MaxiFi simulates the range of potential annual living-standard paths for your current investment strategy X, calculates your lifetime utility arising under each path, averages these lifetime utilities and then compares this average with the average arising under safer and riskier alternative investment strategies, Y and Z. By trying different X, Y, and Z strategies, you quickly hone in on the one that maximizes your lifetime utility.

As I’ve just indicated, there is no reason to believe that intertemporal (through time) optimal portfolio choice for any two households is the same. Hence, the single example I’ll now present is not meant to be anything other than suggestive. Until we do a systematic comparison of retirement-plan default investment alternatives using a large data base, such as the Federal Reserve’s Survey of Consumer Finances — something on my research drawing board, we won’t be able to reach any general conclusions.

Still, the fact that the first case I tried generates the striking results it does is remarkable. The case involves the aforementioned hypothetical Jane. All dollar figures are real (quoted in today’s dollars). Jane’s 35, earns and will earn $75K a year until 65, when she plans to retire. Jane lives in Oklahoma, rents a $1,750 per month apartment, and participates in her company’s 401(k) plan to which she and her employer each contribute $3K annually. Jane plans to start Social Security when she retires. She is also expecting to pay $7.5K annually in retirement for out-of-pocket healthcare expenses, including paying for a Medigap policy and a Medicare Part D policy.

If Jane invests in 30-year TIPS, she’ll be able to spend $29,750 year in and year out through age 100 (her maximum age of life) above and beyond covering taxes, including Oklahoma’s surprisingly high state income tax, Medicare IRMAA premiums, and annual rent.

I had MaxiFi compare Jane’s lifetime expected utility, which MaxiFi calls the Comfort Index, from always investing in a 50-50 balanced portfolio (the Current Strategy) versus investing in a lifecycle fund (the Risky Strategy) that has Jane invest 85-15 stocks to bonds through age 50, then 60-40 through age 60, and 25-75 thereafter. The table below compares the two strategies under different assumptions about Jane’s ability to tolerate risk. The lower is Jane’s risk tolerance, i.e., the higher is her degree of risk aversion, the bigger is her absolute utility loss from a drop of $X in spending compared to the absolute utility gain from a rise of $X in spending.

If Jane can tolerate a lot of risk, lifecycle investing is the big winner. Indeed, lifecycle investing generates as much welfare, on average (in expectation), as holding the balanced portfolio but getting to spend 18 percent more along every discretionary spending path. But if Jane can only tolerate a moderate degree of risk (the risk aversion coefficient in the mathematical formula for utility is of moderate size), lifecycle investing is 8 percent worse. That’s a big difference. But it’s small compared to the case that Jane can tolerate almost no risk. In this case, lifecycle investing is 37 percent worse! Moreover, this comparison doesn’t incorporate the cost of lifecycle investing. Since balanced investing entails no “investment management,” even by a computer, there will be no basis to charge workers fees that have no basis.

Conclusion

I tried different assumptions for Jane. If her rent or old-age, out-of-pocket healthcare expenses are lower, lifecycle investing looks better even when Jane can tolerate very little risk. Recall that fixed expenses are effectively negative bond positions. Hence, it’s natural that Jane would seek to de-risk, i.e., hold more bonds relative to stock, when she faces fixed spending obligations. But this speaks to the point made above — one size does not fit all. Thus, employers should consider taking a financial Hippocratic oath — First do no financial harm. — in overseeing their retirement plans. In particular, they can act in accordance with this oath by making long-term TIPS investing their retirement plans’ default investment.

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