In 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.
The quantitative model from Lyxor could provide optimal exposure adjustments to pension fund managers in changing market environments. For example, by analyzing the theoretical behavior of the solution, Lyxor shows that the optimal exposure is better described in terms of risk budget than directly in terms of weightings. Accordingly, Lyxor said pension fund managers should decrease their equity exposure as volatility increases.
The optimal equity/bonds allocation heavily depends on the investor’s income profile. Most traditional TDFs propose the same predetermined weightings to a whole generation, whereas Lyxor’s quantitative approach takes the investor’s individual characteristics into account and proposes a tailor-made level of risk for each pension fund.
Lyxor said its research could help pension funds adapt their strategies to the needs of their individual members. For example, incomes in major listed companies can be highly correlated to stock markets. A pension plan for this sector should not invest in equities, Lyxor said, as pension members could lose both their job and their savings during an equity crisis. On the other hand, pension funds in the public sector should have a high exposure to equities as their members have very safe income and have a good position to take more risks.
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