Over the last few decades governments have been increasingly moving retirement investing decisions away from companies and onto individuals. Unsurprisingly – at least to anyone who spends any time in the real world – this has led to a lot of poor pensioners and rich fund managers. Slowly, the world has begun to recognise that simply entrusting people with responsibility for managing their own savings is quite a dangerous thing to do: people don't behave as the models predict. Frankly people don't even behave as they themselves predict.
In response to this we're beginning to see the creation of a set of default investing options designed to remove some of the behavioural effects from the process. Amongst these is the idea of the lifestyle fund which defaults investors into a set of investment options that changes as they get older. While this is, in theory, a goodish idea, it doesn't come close to addressing a fundamental problem which is that people's wealth is constituted of both their savings and their ability to earn in future. If your job is safe as a bond then investing in shares is probably a good thing, but if it's not then the default option may be utterly non-optimal.
Over the last couple of decades changes to accounting rules have forced companies to estimate their pension liabilities a bit more than they used to. Which isn't saying a lot, to be honest. Anyway, some of the world's largest corporations, including the majority of its airlines, have suddenly discovered that they're no longer global behemoths bestriding the world but are, in fact, glorified pension funds with small businesses tacked on the end.
Governments too are becoming uncomfortably aware that their future pension liabilities exceed their potential tax take and having paid today's pensioners with money raised from today's taxpayers are trying to figure out how to tell the latter that they've been stiffed rotten by the oldies. All of this retirement malarkey has led to politicians and corporations starting to push onto individuals the responsibility for figuring out how to save for their retirement.
It's taken a while but it's eventually become clear that this process has led to a relatively small number of fund managers looking forward to a very long and comfortable retirement and a very large number of ordinary employees looking forward to living on a diet of beans and daytime TV. As we know, it's turned out that most people aren't very good at investment. Mostly they choose whatever default option is offered to them – which often has meant they haven't bothered saving at all. When they do choose they have a nasty tendency to invest equal amounts in all the options offered, which leads to bizarrely skewed portfolios, rather like choosing one of everything on a supermarket shelf: 42 varieties of sugar-enhanced cereals and an apple, anyone?
Worst of all, however, they have no idea of how to manage their investments at the different stages of their lives. What may be a perfect sensible equity only pension choice at thirty is a devastatingly dangerous one at sixty: you can take a stockmarket crash in your stride early in your life but the closer you get to ending your earning days the bigger the risk is. This observation has led to the rise of the lifestyle fund in which the fund manager takes responsibility not just for the portfolio selection but also for changes to it as people grow older: equities early on, bonds later, sort of thing.
As we saw in Save More … Tomorrow the idea of defaulting people into retirement savings funds that are in their own best interest seems to work and a study by Olivia Mitchell and colleagues shows the same effect for lifestyle funds – if an employer designates such funds as the default choice the adoption rate increases by 66%. Additionally they seem to be attractive to people with low levels of financial literacy making voluntary decisions. The researchers also point out that there's a spillover effect as some investors use lifestyle funds as an element in a mixed portfolio. Overall, though, the impact is the desired one – a more balanced set of investments:
"For pure investors electing lifecycle funds on a voluntary basis, adopting the lifecycle offerings boosts equity exposure with age, eliminates extreme asset allocations, enhances portfolio efficiency, and reduces nonsystematic risk exposure".
All of which isn't a bad idea, apart from the fact that it tends to assume that we're all the same.
But we're not all the same: each us is different economically speaking because each us brings with us a different store of human capital. Some of us are stocks and some of us are bonds and treating those two imposters both the same is equivalent to lumping an A list Hollywood star and a bit-part commercial actor in the same category and then wondering why the former's a lousy tipper.
So what's human capital? Wikipedia defines it as: "the stock of competences, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value."
This, of course, is why we rarely quote from Wikipedia.
Risk and Lifestyle
Turning that into English it's basically whether you have skills that can usefully be transformed into cash. Such skills can be immensely valuable if they're hard to replicate and if you're a brain surgeon you may well have a very long and lucrative career ahead of you sawing away on human heads. On the other hand if your main ability consists of pushing trolleys about a car lot then your store of human capital is, to be frank, rather on the low side. You should perhaps consider using your limited skills to retrain as something slightly better – a stockbroker perhaps. "Better" of course does not necessarily equate to "more useful".
At any given time each us has a capital value that consists of a combination of our physical capital – the value of our possessions including cash, investments, property and so on – and our human capital. Intuitively we can see that if our human capital is high – our future earnings prospects are good – then we can afford to take a few more risks with our physical capital. The reverse is also true, of course – it doesn't make much sense for our car lot attendant to be gambling on stocks with cash they may never be able to replace.
Inevitably, therefore, lifecycle funds will lead to younger car lot attendants being misallocated equity funds and older brain surgeons pushed into pointless bonds. As Luis Viceira point outs in Life-Cycle Funds:
"Arguably there is considerable heterogeneity amongst investors with respect to their risk tolerance and the characteristics of their human capital. Therefore, individually managed funds would be more appropriate than a single asset-allocation fund, since they can take into account these individual-specific characteristics when making asset allocations".
Unfortunately this brings us full-circle to having behaviorally challenged investors managing their own money – badly, usually – or fund managers enriching themselves. Unfortunately there may be an even worse problem because even if the individual decides to use a lifestyle fund they still have to choose which one, and they're not all the same. Here's Viceira again:
"The equity allocations of life-cycle funds and life-style funds are typically heavily biased towards US stocks … The empirical evidence available suggests that a well diversified portfolio of equities should include a healthy allocation to international equities".
Fund managers are just as prone to behavioral mistakes as individuals: they just do them on a grander scale. However, on the positive side, the re-framing of complex portfolio decisions over time into a relatively simple one – buy a lifestyle fund – you would think has to be an improvement for most people. The question is whether it's possible to get them to adopt them.
The brutal reality appears to be that a dose of paternalism is good for most investors, regardless of their human capital. Naïve investors especially benefit, probably at the expense of the more sophisticated individuals who continue to invest in their own unbalanced portfolios for the same reason they prefer to drive a car over taking public transport – the misguided belief that their life and their savings are safer in their own hands. Maybe even brain surgeons need some decisions taken out their hands, however safe they might be.