The Theory of Life-Cycle Investing
Conventional wisdom suggests younger individuals should invest more of their savings in riskier assets (e.g., stocks), while older individuals should invest more of their savings in safer assets (e.g., government bonds). This age-based approach has its roots in the theory of life-cycle investing, which dates back to the 1950s in academic literature.
A key concept underpinning life-cycle investing is every individual investor has two types of wealth. The first type is financial wealth, the measure of wealth that is most familiar to us. It is held in instruments such as currency, bank deposits, equity interests (or stock) in private or publicly-held businesses or real property, financial claims (or bonds) on governments or businesses (and individuals in certain cases), contracts with insurers, physical commodities, and funds comprised of one or more of these instruments. The second type of wealth is human capital — the value of all expected future income from working. Total wealth is the sum of financial wealth and human capital.
Human capital usually accounts for a very large fraction of total wealth for younger investors. The ratio of human capital to total wealth declines as the individual ages until it reaches zero at retirement. Life-cycle investing theory assumes human capital is less risky than financial wealth for most individuals. The theory suggests human capital is somewhat like a bond, such that younger investors can afford to invest a larger proportion of their financial wealth in stocks or other risky assets. Investors at or near retirement should have a lower allocation to risky assets since most or all of their wealth is in financial assets. In addition, the theory suggests investors can afford to take more risk with their financial assets when they are younger because if they lose money they can work longer or harder (or both!) than they otherwise planned. This flexibility to adjust how much one works is slowly lost as the individual ages and argues for taking less risk with accumulated financial wealth.
Life-Cycle Investing in Practice
Financial practitioners have employed the theory of life-cycle investing with their clients for decades. Sometimes it is done with a high degree of precision, utilizing a formulaic approach that steps down risky asset exposure as the client ages. More often, the asset allocation is determined using “rules of thumb” or less formal approaches that place more financial wealth in stocks if the investor is younger and more financial wealth in bonds if the investor is older.
Defined contribution employer retirement plans in the United States, including 401(k) and 403(b) plans, have steered more plan participants into funds based on the life-cycle investing approach. These funds go by various names — “target date” funds, “life cycle” funds, “age based” funds, or “dynamic risk” funds. Regardless of the name, the approach is the same.
These funds tend to put 85–100% of assets in stocks for investors up to around age 40. By age 65, the stock allocation is reduced to 40–50% and the majority of the fund assets are sitting in bonds or cash. Certain funds aimed at those already retired have even more conservative asset allocations. In between ages 40 and 65, these funds step down the exposure to stocks according to a chosen formula, dubbed the “glide path”. The exact allocations to stocks by age will vary by fund provider, but all follow this basic pattern. The figure below illustrates the stock allocation by participant age for a typical target date fund.
Figure 1. Target Date Fund Asset Allocation Illustration
Target date funds now manage more than a trillion dollars of wealth in the U.S., with the vast majority of these funds held within employer retirement plans. Their popularity grew following the passage of the Pension Protection Act of 2006. This federal law encourages employers to automatically enroll employees in workplace retirement plans. If an employee participating in a plan with automatic enrollment fails to designate their own investment choices, then the employer can direct those funds into one of three default options approved by the U.S. government — either a target date fund, a fund with a balanced mix of stock and bonds, or a professionally managed account. Target date funds have become the dominant default choice of most employer plans given the broad support of life-cycle investing theory among financial practitioners.
Life-Cycle Investing’s Flaws and Consequences
A theory is useful only if its underlying assumptions are valid. Unfortunately, the key assumptions underpinning life-cycle investing theory do not necessarily hold true for many individuals.
The riskiness of human capital appears to be more akin to that of stocks than bonds for an increasing proportion of the population. Recent research has provided evidence of increased household income volatility since the 1970s. Part of this may be due to the changing nature of work that results in people switching jobs more frequently than in previous generations. In 2017, the U.S. Bureau of Labor Statistics released data from an ongoing longitudinal study that showed people born in the latter part of the post-World War II baby boom (1957-1964) held an average of 6 jobs between ages 25 and 50. It seem likely that the number of jobs held by later generations will be even greater given the pace at which technological innovation is disrupting most industries.
We acknowledge that volatility is not inherently the same as risk. The range of lifetime incomes for the typical household may be more predictable than the range of future returns from risky assets like stocks, particularly if the household has sufficiently insured itself against the long-term disability or premature death of its earners. However, the empirical evidence is not supportive of the notion that household income risk is low compared with risky financial assets. If we do not have confidence that human capital is less risky than stocks, it follows that the proportion of human capital to total wealth is no longer a key driver of the optimal allocation of financial wealth. In other words, age should no longer be the principal determinant of the appropriate mix of stocks in an individual’s portfolio.
The assumption that labor flexibility enables investors to take more risk with their financial assets when they are younger is more difficult to dismiss entirely. The flexibility to adjust total lifetime hours worked necessarily declines with age. But this flexibility is limited even for younger households. This is particularly true for a household with dependent children, or a household that includes sick or aging family members that require substantial care. Although life spans have increased in recent decades, it is not evident that most of us will be able to continue our prime-age profession into what are normally retirement years if our financial assets fare poorly. As we age, the incidence of chronic illness rises, potentially limiting our ability to work longer even if desired.
Once the standard assumptions of human capital risk and labor flexibility are shown not to hold for an individual, we need to assess whether the life-cycle investing approach still has practical merits. Life-cycle investing undoubtedly will deliver a relatively high expected return given the elevated allocation to riskier assets until middle age (around age 40). The potential for low or negative returns also is greater, but most of the time the individual will find themselves better off in early middle age than if they had invested more conservatively. The key exception will be younger individuals with low investment risk tolerance. Low risk-tolerance investors will be more prone to selling risky assets like stocks after prices have fallen sharply and thereby damage their lifetime wealth accumulation prospects.
When middle age is reached, the “glide path” formula of the chosen life-cycle product will step down the allocation to riskier assets each year until the investor nears retirement. Unfortunately, the “glide path” period of life-cycle investment introduces a new risk, known as "sequence-of-returns risk". Sequence-of-returns risk refers to the phenomenon that the order or sequence of investment returns may affect lifetime outcomes when an individual is liquidating financial assets or changing their asset allocation. This risk is most commonly associated with the asset drawdown strategies of retirees, but we argue it is an underappreciated risk of any investing approach in which the asset allocation is automatically adjusted regardless of recently experienced returns and future expected returns.
In the case of life-cycle investing, allocations to stocks are typically reduced by 50 percentage points or more over a period of 25 years. That works out to only a few percentage points of change in the stock allocation per year, but the consequences of selling stocks following a market correction or crash can be significant. For example, the S&P 500 experienced peak-to-trough declines of 57% from late 2007 to early 2009 and 49% from early 2000 to late 2002. Selling even a small percentage of stocks during such bear markets will permanently damage an investor’s wealth compared with a scenario of steady annual returns from all asset classes. There were 11 instances over the 25-year period through early 2018 that saw U.S. stock market declines of 10% or more. We estimate life-cycle investing could result in as much as 5% of wealth being lost over a similar 25-year period relative to an approach that didn’t require stock sales during market downturns.
Once an investor reaches retirement, the life-cycle investing approach will dictate a more conservative asset allocation. This will be appropriate for some, but many individuals will need to manage their "longevity risk", i.e., the risk of outliving their money. This risk grows with each subsequent generation as medicine improves. And longer lives increase the incidence of chronic conditions that require costly care. A greater number of people will need to prepare for retirements that could be as long as 35 or 40 years. A conservative asset allocation may not provide sufficient returns to mitigate longevity risk depending upon one’s savings at retirement.
In our view, the flaws of life-cycle investing are evident for investors of all ages. The consequences of these flaws are the most benign for the very young with a high tolerance for risk, but increase through middle age with the introduction of sequence-of-returns risk, and are perhaps most serious for retirees that require decades of support from their savings. We argue that a customized investing approach may provide superior outcomes for most individuals and their families. Such an approach would deliver investment portfolios that are optimized for the individual’s investment risk tolerance and that respond dynamically to changes in the outlook for investment returns and risks.