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Off-the-peg solutions seldom a good fit
This article featured in The Australian on 15 July 2009 and can also be viewed on The Australian website.
Terry Dillon is a senior financial adviser at Plan B Wealth Management.
ALTHOUGH those of us who work in the financial services industry aren't exactly known for our sartorial flair, there is one striking, if somewhat alarming parallel between the fashion and financial services industries.
Just as designers from the big retail chains flock to the likes of Milan Fashion Week to pick up on the latest trends, with a view to creating successful mass-market products, so too the antennae of investment companies are constantly aquiver to detect the latest trends on the financial horizon, with a view to creating the new must-have thing for investors everywhere.
Never mind that last year's hot product is this year's financial embarrassment. Investment companies that only a short while ago were the proud purveyors of highly leveraged investment products are now telling customers that safe is the new black.
Remember that sophisticated hybrid product you bought a couple years back? You'd feel ashamed even bringing it up at the weekend barbie now.
The global financial crisis has, of course, changed the landscape of much of the investment industry.
But before the first green shoots of recovery have so much as been confirmed, there are those cognoscenti who say they have a solution to what went wrong. Taking note of the fear that has had so many investors in its paralytic grip for the past year, they offer a product which ensures that even if stockmarkets should repeat their dire performance of 2008 at some point in the future, investors should have no fear: their money will be in safe hands.
The wonder products are called life-cycle funds, or target-date funds.
They are already among the fastest growing pension fund options in US and their presence is increasingly being felt in Australia.
While they aren't an especially new creation, the wild ride on global stock markets in recent times has boosted their profile enormously.
On the surface, life-cycle funds do seem to have it all.
The basic premise is that as we move through our earning lives, our investment portfolio should be revised to reflect our changing circumstances.
When we are younger, looking to build our core wealth and with the capacity to withstand market volatility, our focus should be on growth assets such as shares.
As we get older, having increased our investments, and with less time to wait for a recovery from big market downturns, our portfolio should shift more into so-called defensive assets, including cash and bonds.
When you join a life-cycle fund, your age and planned retirement date are used to decide on asset allocation, you are invested into a fund, and your glide path is set. Much like the autopilot function in an aircraft, from then on the asset allocation of your portfolio is automatically adjusted, offering you the peace of mind of knowing that whatever happens along the way, your core wealth is being managed in accordance with best investment practices.
That, at least, is the theory.
But, as John Lennon famously observed, life is what happens to you while you're busy making other plans, and herein lies one of the main problems with target-date funds: their inflexibility.
What happens if, as you glide towards your golden years, an automatic switch from equities to cash is triggered, only it's the bottom of the worst bear market in living memory?
This is exactly what has happened to many baby boomer members of life-cycle funds in the past year, who have discovered, to their horror, that their funds offloaded shares for 40 per cent less than their former prices, crystallising losses that will never be regained in the conservative investments to which they have been allocated.
With markets having rebounded by about 25 per cent since March, had some of these automatic sell-offs been delayed by only months, the losses would have been less devastating.
It's also quite possible that many of the investors are in a position to wait much longer for markets to recover but, unfortunately for them, that's an option they've been denied.
Another basic problem with life-cycle funds is the age at which investors are switched out of growth assets and into fixed interest.
The assumption is that your retirement from work marks your withdrawal from the majority of growth assets. Your nest egg at that point, according to this premise, is as big as it's going to be. From then on, you're placed in protection mode.
Once again, this approach is at odds with reality, where the majority of people choose 60 as their retirement age and then have the temerity to go on living for another 20 years.
Twenty years is a very long time to forgo the benefits of holding any growth assets at all.
In the real world, many retirees continue to enjoy robust returns from growth assets well into their 60s. In fact retirement guru Don Ezra has an intriguing 10-30-60 ratio suggesting that, of a fund member's total amount available to pay retirement income, only 10 per cent arises from contributions, 30 per cent from earnings during one's working life, and a whopping 60 per cent comes from growth that occurs in the fund after retirement.
The truth is, despite the buzz about target-date funds, no manufactured investment product is going to suit clients as well as the investment plan that's designed specifically to meet their needs, and modified on an ongoing basis.
While the product manufacturers bang on about what's hot and what's not, with their off-the-peg solutions that never quite fit, at the other end of the spectrum, barely recognisable as part of the same industry, are those firms that start with the client's individual circumstances, a tape measure and an ever-watchful eye.
There may be less glamour attached to tailored solutions, but over time the results speak for themselves.
AT A GLANCE
LIFE-CYCLE funds are one of the fastest growing pension fund options in the US and interest is increasing here.
FUNDS move away from growth assets such as equities as a person ages and security of income becomes more important.
BUT such funds pay insufficient attention to market movements and can lock in losses.
MOVING away from growth assets in retirement could deny retirees much-needed income.