Life cycle versus balanced funds : an emerging market perspective

Abstract

BACKGROUND : Inadequate retirement savings is an international challenge. Additionally, individuals are not cognisant of how asset allocation choices ultimately impact retirement savings. Life cycle and balanced funds are popular asset allocation strategies to save towards retirement. However, recent research is questioning the efficacy of life cycle funds that switch to lower risk asset classes as retirement approaches. AIM : The purpose of this study is to compare the performance of life cycle funds with balanced funds to determine whether either dominates the other. The study compares balanced and life cycle funds with similar starting asset allocations as well as those where the starting asset allocations differ. SETTING : The study has a South African focus and constructs funds using historical data for the main local asset classes; that is, equity, fixed income and cash, as well as a proxy for foreign equity covering the period 1986–2013. METHOD : The study makes use of Monte Carlo simulations and bootstrap with replacement, and compares the simulated outcomes using stochastic dominance as decision-making criteria. RESULTS : The results indicate that life cycle funds fail to dominate balanced funds by first-order or almost stochastic dominance when funds have a similar starting asset allocation. It is noteworthy that there are instances where the opposite is true, that is, balanced funds dominate life cycle funds. These results highlight that while the life cycle funds provide more downside protection, they significantly supress the upside potential compared to balanced funds. When the starting asset allocations of the balanced and life cycle funds differ, the stochastic dominance results are inconsistent as to the efficacy of the life cycle fund strategies considered. CONCLUSION : The study shows that whether one fund is likely to dominate the other is strongly dependent on the underlying asset allocation strategies of the funds. Additionally, the length of the glide path and the risk and return characteristics of the investable universe are also likely to influence the findings.