October 30, 2012
--- Lyxor has developed a new approach to target-date funds (TDFs) to ensure
proper retirement benefits. ---
Lyxor Asset Management’s white paper, "How to Design Target-Date Funds," the
firm’s research arm, Lyxor Research, details an approach to TDFs that
takes into account allocation, portfolio theory and exposure.
As the firm points out, as people live longer, investors will
increasingly need to save sufficiently for retirement. In terms of pension
investment, the default funds offered by defined contribution (DC) plans are
proving popular. Investors are particularly attracted to TDFs (designed to suit investors who will retire around a similar date) given their
simple and straightforward approach to saving.
TDFs are designed to collect the
clients’ savings throughout their entire working life, in order to maximize benefits in retirement. These funds’ allocation process takes the
investor’s lifecycle into account. In DC
pension plans, younger participants invest, on average, 27% of their assets in
such investment vehicles.
Lyxor’s approach calls for TDFs to
be aligned with modern portfolio theory, not general industry consensus. Generally,
these funds share the same allocation behavior. They are mostly invested in
equities at inception, when investors are young, whereas the allocation will be
more heavily weighted toward bonds and cash as the clients approach retirement.
This behavior corresponds to popular advice in the financial industry, but Lyxor said it lacked theoretical foundations until now. Modern portfolio theory says that
optimal investment decisions should not take the horizon into account. Accordingly,
investors should hold a constant proportion of equities and bonds over time, which Lyxor said contradicts the general behavior of the industry. Therefore, the
allocation processes of TDFs remained unclearly motivated.
Investors should hold a stable proportion of their "human capital" in equities over time. Lyxor research explains this industry practice by the
future income profile of investors. The research calls for investors to invest
a stable proportion of their "human capital" in equities over time. So-called
human capital is defined as the current capital plus the present value of
future savings. Human capital would outweigh current capital for young
investors, but both would converge as retirement approaches. As such, Lyxor said the
portfolio should be overweighed in equities for young investors, in
terms of current capital.