A little knowledge is a dangerous thing.
The old saying “a little knowledge is a dangerous thing” applies to most things in life, but particularly so when it comes to investment matters.
I am intrigued to see that one KiwiSaver provider is currently running a promotional campaign to “Wake up your KiwiSaver”. The promotion rightly highlights the critical importance of the asset allocation decision (i.e. how much of your fund is allocated to growth assets, such as shares) on your likely capital balance at retirement. This point is particularly relevant for those who did not actively select a KiwiSaver fund when they joined and were allocated a Default Fund. Under the current rules the Default providers must hold the majority of their investments in cash and fixed interest.
One concern that I do have about this call to action, is that any increased exposure to shares will increase the probability that a KiwiSaver member will experience a short-term loss. It has been shown that1, on average, investors are twice as fearful of losses than they are appreciative of gains of the same magnitude. This means that it is essential that KiwiSaver members understand how to manage losses and when they should have an increased exposure to shares.
For most people the correct mix of investments comes about through a 'tug of war' between their emotional ability to tolerate risk and their practical need to maximise their return. It’s a battle between the growth and volatility offered by shares and the perceived stability and certainty that comes with fixed interest investments. To further complicate things the outcome of this tug of war changes over time.
When we are young and have time to recover from a difficult investing period it makes technical sense, and is emotionally easier, to have a higher allocation to shares. However, as we move into our mid-fifties the emotional need to experience less volatility becomes increasingly important as we are approaching the time where we will start to draw on at least part of our retirement capital.
Overseas, this paradox has led to the development of what are referred to as End Date Funds. These funds start life with a higher exposure to growth assets and then progressively modify the asset allocation to become more conservative with the aim of delivering a specific dollar figure, or agreed asset allocation, at retirement.
In New Zealand, several KiwiSaver providers have developed offerings which apply the same approach. Such products are often called Lifecycle funds. With these funds the manager links the members’ age with a specific asset allocation and, as the member ages, their exposure to growth assets is automatically reduced. They provide an important protection against a KiwiSaver fund which was 'woken up' at age 35 but inadvertently causes sleepless nights at age 58 because it is unsuitable for that particular client’s temperament and age.
However, a recent research paper2 on the use of these lifecycle type products in New Zealand has identified a number of potential pitfalls.
In conclusion annually reviewing the asset allocation of all of your investments makes sense. Automated processes to help you manage your asset allocation can be helpful. However, it is important to understand the thinking that drives the process and the possible short and long term implications.
1. Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. Daniel Kahneman; Jack L. Knetsch; Richard H. Thaler, The Journal of Economic Perspectives, Vol. 5, No. 1, pp. 193-206.
2. Review of LifeCycle Products. Rae, D. MyFiduciary, August 2019.
I am intrigued to see that one KiwiSaver provider is currently running a promotional campaign to “Wake up your KiwiSaver”. The promotion rightly highlights the critical importance of the asset allocation decision (i.e. how much of your fund is allocated to growth assets, such as shares) on your likely capital balance at retirement. This point is particularly relevant for those who did not actively select a KiwiSaver fund when they joined and were allocated a Default Fund. Under the current rules the Default providers must hold the majority of their investments in cash and fixed interest.
One concern that I do have about this call to action, is that any increased exposure to shares will increase the probability that a KiwiSaver member will experience a short-term loss. It has been shown that1, on average, investors are twice as fearful of losses than they are appreciative of gains of the same magnitude. This means that it is essential that KiwiSaver members understand how to manage losses and when they should have an increased exposure to shares.
For most people the correct mix of investments comes about through a 'tug of war' between their emotional ability to tolerate risk and their practical need to maximise their return. It’s a battle between the growth and volatility offered by shares and the perceived stability and certainty that comes with fixed interest investments. To further complicate things the outcome of this tug of war changes over time.
When we are young and have time to recover from a difficult investing period it makes technical sense, and is emotionally easier, to have a higher allocation to shares. However, as we move into our mid-fifties the emotional need to experience less volatility becomes increasingly important as we are approaching the time where we will start to draw on at least part of our retirement capital.
Overseas, this paradox has led to the development of what are referred to as End Date Funds. These funds start life with a higher exposure to growth assets and then progressively modify the asset allocation to become more conservative with the aim of delivering a specific dollar figure, or agreed asset allocation, at retirement.
In New Zealand, several KiwiSaver providers have developed offerings which apply the same approach. Such products are often called Lifecycle funds. With these funds the manager links the members’ age with a specific asset allocation and, as the member ages, their exposure to growth assets is automatically reduced. They provide an important protection against a KiwiSaver fund which was 'woken up' at age 35 but inadvertently causes sleepless nights at age 58 because it is unsuitable for that particular client’s temperament and age.
However, a recent research paper2 on the use of these lifecycle type products in New Zealand has identified a number of potential pitfalls.
- The research shows that most lifecycle type products are too conservative in both the preretirement and post retirement phases. This means that they don’t have sufficient exposure to growth assets. A more conservative asset allocation is less likely to deliver acceptable retirement incomes for the typical user. This is particularly important in a low interest rate environment.
- The frequency with which the asset allocation is adjusted is important. With some offerings the modification of the asset allocation only occurs at 5-year intervals (rather than annually or more frequently). The risk with this approach is that, as the time between rebalancing is so great it requires a larger incremental change. This can lead to a situation where a client’s outcome can be heavily influenced by market events around the scheduled asset allocation change points.
- The transition from a growth bias to a more balanced or conservative bias should not start too early. With many lifecycle providers the transition away from a growth bias starts when clients are aged in their thirties and forties. The research suggests that this is too early and that maintaining a growth bias for longer, and then transitioning more rapidly later, is more likely to meet clients’ needs.
In conclusion annually reviewing the asset allocation of all of your investments makes sense. Automated processes to help you manage your asset allocation can be helpful. However, it is important to understand the thinking that drives the process and the possible short and long term implications.
1. Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. Daniel Kahneman; Jack L. Knetsch; Richard H. Thaler, The Journal of Economic Perspectives, Vol. 5, No. 1, pp. 193-206.
2. Review of LifeCycle Products. Rae, D. MyFiduciary, August 2019.
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Peter Ashworth is a Principal of New Zealand Funds Management Limited, and is an Authorised Financial Adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily those of NZ Funds. His disclosure statements are available on request and free of charge.
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First published in the Otago Daily Times on 7 October 2019, as ‘KiwiSaver members need to identify correct mix.’
