Lifecycle products are an alternative to a balanced/ diversified investment strategy for MySuper products.[1] A superannuation trustee can also offer a lifecycle option as a choice product. This article explores some of the issues trustees should address in managing MySuper lifecycle products.
What is a Lifecycle fund?
In lifecycle funds, the investment strategy changes as the member ages, typically reducing exposure to risk as the member approaches retirement age (the target date). The Australian Prudential Regulation Authority (APRA) describes a lifecycle investment strategy as:
"… one that varies the asset allocation for a beneficiary according to factors such as their age and/or the time remaining to retirement. It typically consists of multiple strategic asset allocations, each one assigned to a cohort of members of the same lifecycle group, e.g. age range, retirement time horizon, account balance."[2]
Two lifecycle models are popular:
- the asset allocation changes when the member reaches predetermined ages, or at a predetermined period before expected retirement; or
- the member is placed in a cohort of members in a particular age range (for example, members born in a particular decade), with the same investment strategy applied to each member of the age cohort.
The common feature of both models is that the allocation between "growth" and "defensive" assets changes, typically starting with a higher allocation to "growth" assets when the member is younger and has a longer investment horizon, and increasing the allocation to "defensive" assets as the member ages or approaches retirement age. The progressive reduction in risk is often described as a "glide path". If all goes to plan, the member will experience higher investment returns (with potentially higher volatility) in the earlier years, and lower investment returns (with potentially lower volatility) in the pre-retirement years.
The different return objectives and risk objectives in each stage represents the trustee’s judgment of an appropriate trade-off between the potential for growth and the risk of loss. Adopting a lower risk strategy leading up to the member’s retirement date emphasises certainty over returns.
Lifecycle in MySuper — legislative requirements
The characteristics of a MySuper product are defined in s 29TC of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS). These characteristics include:
"(a) a single diversified investment strategy is to be adopted in relation to assets of the fund, to the extent that they are attributed to that class of beneficial interest in the fund [ie. the MySuper interest]; and
(c) amounts are attributed to members in relation to their beneficial interest of that class in the fund in a way that does not stream gains or losses that relate to any assets of the fund to only some of those members, except to the extent permitted under a lifecycle exception (see subsection (2));"
Section 29TC(2) of SIS provides:
"A lifecycle exception is a rule under the governing rules of the fund that allows gains and losses from different classes of asset of the fund to be streamed to different subclasses of the members of the fund who hold a MySuper product;
(a) on the basis, and only on the basis, of the age of those members; or
(b) on the basis of the age of those members and other prescribed factors; or
(c) on the basis of the age of those members and other prescribed factors in prescribed circumstances."
Regulation 9.47 of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SIS Regulations) provides:
"For paragraph 29TC(2)(b) of the Act the factors are:
(a) the member’s:
(i) account balance; and
(ii) contribution rate; and
(iii) current salary; and
(iv) gender; and
(b) the time remaining, in the opinion of the trustee,
before the member could be expected to retire."
The MySuper fee charging rules in s 29VA of SIS permit lifecycle differentiated investment fees. Section 29VA(9) of SIS requires the same flat fee, percentage fee or combination of flat fee and percentage fee to be charged as an investment fee to members in the same age cohort. Although there is no limit on the number of lifecycle categories for which a different investment mix can be applied, there can be no more than four separate fee scales, based on age cohorts.[3]
Section 29VA(9) does not compel a trustee to adopt differentiated investment fees for different member cohorts. However, if a different investment fee is adopted for different cohorts the difference should "reflect a reasonable attribution of the investment costs of the fund between the age cohorts".
Investment strategy
The overall investment strategy for a Lifecycle fund must be "diversified". The investment strategy for each category must be the same for all members of the category.[4]
Asset classes
The combination of sections 29TC(1)(a), (c) and (2) suggests that a MySuper lifecycle strategy represents a variation of an overall diversified strategy. A question arises as to whether a MySuper lifecycle strategy could exclude certain asset classes altogether from different lifecycle categories, provided that the overall strategy could be described as "diversified".
Two alternative interpretations are possible.
The first alternative is that the investment strategy for each lifecycle category must be diversified across the same asset classes as all other categories, but that the weightings to each asset class can be different.
The second alternative is that the overall strategy across the lifetime of the member’s investment is diversified, but in some lifecycle categories the member could have no exposure to a particular asset class. An example of the second alternative would be a fund that offered:
- at the high growth end of the spectrum, a lifecycle category for a young member with exposure to a high risk asset class such as emerging market equities and no exposure to cash; and
- at the defensive end of the spectrum, a lifecycle category for an older member with no exposure to emerging market equities and a high exposure to cash.
The second alternative could enable trustees to introduce different drivers of growth and risk management at the high growth and defensive ends of the lifecycle range that may not be suited to the middle "balanced" parts of the lifecycle.
Assets held by trustee
The requirement for a MySuper product to have a diversified investment strategy could be satisfied by investing in a single asset — for an example, an investment linked life policy with an insurance company — or owning units in a single trust, provided the investment strategy is "diversified".
The lifecycle exception permits "gains and losses from different classes of asset of the fund to be streamed to different subclasses of members".[5] This implies that the fund must hold "different classes of asset". Trustees should therefore consider whether the investments held for a MySuper lifecycle product should include different assets (for example, unit trust investment, or different units under an investment linked life policy) for each asset class making up the overall diversified strategy, to enable returns to be streamed.
Investment reserves in funds that apply a crediting rate
Some funds use investment reserves in conjunction with crediting rates to smooth investment returns over time. If the period remaining to the member’s expected retirement is less than the period over which investment fluctuations are smoothed, the member may miss out on the benefit of earnings retained from high earning periods that are not credited before the member reaches retirement.
Under the MySuper lifecycle rules a trustee could create a pre-retirement MySuper lifecycle category and apply a different crediting rate policy for those members, to accelerate the smoothing of returns and ensure that retiring members receive the benefit of previous good performance that would not otherwise be credited until after they retire.
Lifecycle categories — age and other relevant factors
A trustee can take into account the member’s age and the factors set out in SIS reg 9.47 to construct member cohorts or categories for a MySuper lifecycle product. Age is a required factor in any member category. Different categories can be established on the basis of:
- the age of the member and one or more of the following factors — account balance, contribution rate, current salary, gender; and
- the age of the member and the expected time to retirement.
The existing rules give a trustee significant flexibility within a MySuper product. For example, assume a trustee differentiates between four age cohorts, three account balance categories (low/medium/high), three contribution rates (low/medium/high), three current salary bands (low/medium/high) and both genders. This would generate 216 separate lifecycle categories. Common sense suggests that a trustee is unlikely to introduce so many categories, but the example shows that the trustee has many options. In deciding on the lifecycle stages or member segments, the trustee should consider what lifecycle factors justify a decision to adopt a strategy that is different than other members.
Balance, contribution rate and salary
If a trustee is pursuing a retirement adequacy objective, the trustee may reasonably conclude that members with low account balances, low contribution rates or low current salaries need a higher growth strategy to generate a retirement benefit that provides adequate economic support in retirement. The writers are aware of one fund that differentiates on the basis of age and account balance, applying a higher growth target (and therefore a higher risk target) to lower balance members in each age grouping.
The trustee could also take into account the availability of the age pension in determining the investment strategy for low balance members. A trustee may consider it is promoting the financial interest of a member to adopt a higher return/risk objective to increase the retirement benefit to a level that, if converted to a retirement income stream, would provide an "adequate" level of retirement income (above the age pension), in the knowledge that the age pension provides a safety net if return objectives are not met due to market risk.
Gender
A trustee may consider that differentiation on the basis of gender is justified because women have, on average, a greater life expectancy than men. If a woman is expected to live on average 2 ½ to 3 ½ years longer than a man, the woman may need to generate a retirement benefit that supports a retirement that lasts 10 to15 percent longer than a man of the same age. A trustee may consider this justifies adopting a higher growth strategy for longer, to generate a bigger retirement benefit.
A possible variation — promoting generational recovery
One novel possibility is that a trustee could adopt a higher growth strategy for an age cohort if, as a result of sustained long-term low-growth conditions during the working life of those members, their retirement balances are likely to fall short of an expected target to provide an adequate retirement benefit. However, adopting a higher growth and risk target nearer to retirement would be inconsistent with the way lifecycle products and their "glide path" are typically depicted.
General requirements
In developing and implementing a lifecycle strategy, whether as the MySuper default option or as a choice product, the trustee must comply with the investment covenant in section 52(6), Prudential Standard 530 — Investment Governance, and other applicable duties, including the other covenants in section 52 (and the duty in section 29VN for MySuper products).
The trustee should also take into account the matters set out in SPG 530 Investment Governance. SPG 530.53-60 identify matters a trustee should consider when formulating a lifecycle investment strategy. APRA expects that a trustee "would undertake appropriate analysis to demonstrate that adopting a lifecycle strategy is in the best interest of beneficiaries", and that "[w]here a lifecycle investment strategy is adopted, APRA expects an RSE licensee to be able to clearly outline the reasons for adopting such a strategy and how the strategy is in the best interests of the beneficiaries."
A prudent trustee offering a MySuper lifecycle strategy should also be able to justify how the strategy will promote the "financial interest" of the members in each lifecycle category.
Practical issues
Administrative complexity
In considering whether to adopt a lifecycle strategy the trustee should consider its ability to manage any additional administrative complexity caused by creating different member segments.[6]
Managing transitions between asset allocation ranges
One of the criticisms of lifecycle strategies that change the asset allocation on the member’s birthday is that a shift in asset allocation on an arbitrary date could expose the member to the risk that poor investment performance from a higher return/higher risk strategy in the period before the birthday will not be recovered during a period of higher performance after the birthday, because the member has been shifted to a lower return/ lower risk strategy. This risk can be actively managed to some extent in funds that apply age cohorts to determine the lifecycle category (for example, based on decade of birth) and apply tactical asset allocation strategies to manage the different asset class ranges for each category.
Investment horizon
Choosing an overall "investment horizon" is a fundamental decision in deciding whether to adopt a lifecycle strategy, and in determining the stages of a lifecycle strategy.
In SPG 530 APRA refers to the "investment horizon" in two ways. First, "investment horizon" is used is in relation to the period over which the risk and return objectives of each investment strategy are measured. This period is also relevant to the modelling of returns, risk management assessments and stress testing that a trustee is expected to undertake.[7]
Second, "horizon" is used is in relation to the "retirement time horizon" or "investment time horizon for the entirety of the lifecycle strategy (ie, whether the end date for the final stage is assumed to be the member’s retirement date or their life expectancy)."[8] APRA therefore expects a trustee to consider whether a post retirement date (or life expectancy) time horizon, or a retirement date "target date" time horizon, could lead to different investment strategies for each lifecycle category.
MySuper investment horizon
Can a trustee adopt a post-retirement time horizon for the investment strategy of a MySuper product, given there is no MySuper pension?
Under section 29VN(a) of SIS the trustee must "promote the financial interest of the beneficiaries of the fund who hold the MySuper product, in particular returns to those beneficiaries (after the deduction of fees, costs and taxes)". The legislation indicates that a trustee is expected to take a long term focus. Section 29VN(d) requires the trustee to include in the investment strategy for the MySuper product "the investment return target over a period of 10 years for the assets of the fund that are attributed to the MySuper product" and "the level of risk appropriate to the investment of those assets".
According to the Explanatory Memorandum, the trustee must "promote" the financial interests over an even longer term:
"1.18 The obligation to promote the financial interests of beneficiaries who hold the MySuper product is not limited to a particular period. The trustee must promote the financial interests of beneficiaries over the period they hold, or are expected to hold, an interest in the MySuper product. As most members would be expected to remain in the MySuper product for a considerable period, it will be generally appropriate for trustees to aim to manage returns to those beneficiaries (after the deduction of fees, costs and taxes) over the longer term."[9]
Obviously the trustee can only promote the member’s financial interest while the member holds an interest in the product, and the trustee’s obligation necessarily ends when the member either withdraws a lump sum or rolls it into a retirement product. However, s 29VN and the Explanatory Memorandum do not clearly direct the trustee to adopt the expected retirement date as a "target date" for each member’s benefit. In the writers’ view, the trustee needs to consider if the "financial interest" of the beneficiary is promoted by either:
- focusing on the size and security of the lump sum benefit at retirement date; or
- investing in accordance with a strategy that the trustee considers the member should, or is likely to, maintain in the retirement phase (for example, to generate further returns to extend the period during which the member will be able to draw down in the retirement phase or increase the amount of the draw down).
In the writers’ view, it is open to a MySuper trustee to adopt either approach, provided that it can reasonably justify its choice.
Availability of post retirement products APRA considers that a prudent trustee would take into account the availability of post-retirement products provided by the trustee and the structure of the drawdown phase (for example, periodic payment or lump sum withdrawals) in determining the stages of a lifecycle strategy.[10]
Murray FSI recommendations
The Murray Financial System Inquiry recommendation to introduce a mandatory default retirement product could affect the decisions trustees make in relation to:
- the characteristics defining the lifecycle categories. For example, the pooling of longevity risk may result in higher retirement incomes from a given retirement benefit, potentially reducing the need to take greater risk to generate higher returns for low balance members; and
- risk and return objectives for the investment strategies for each category. This will be particularly relevant if the introduction of a retirement product shifts the target date for the lifecycle "glide path" from retirement age until a later date, such as the average life expectancy or the date from which a longevity benefit would apply.
Conclusion
The MySuper lifecycle exception gives trustees a great deal of flexibility to develop a single diversified investment strategy (static or lifecycle) that is appropriate to their members.
The authors would like to thank John Edstein and Jane Paskin for their generosity in sharing their knowledge and insights about the issues addressed in this article and providing feedback on earlier drafts.
[1] Brendan Swift; "The Lifecycle Equation", ASFA Superfunds magazine, September 2014, p 19 reports that approximately one fifth of MySuper default funds are lifecycle products. Back to article
[2] APRA Prudential Practice Guide SPG 530 Investment Governance, para 53. Back to article
[3] Section 29VA(a)(c) of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS). Back to article
[4] Explanatory Memorandum for the Superannuation Legislation Amendment (MySuper Core Provisions) Bill 2012, para 4.10 Back to article
[5] Section 29TC(2) of SIS. Back to article
[6] SPG 503.54 states: "At the formulation stage of a lifecycle investment strategy an RSE licensee would typically assess its capabilities to implement such a strategy." Back to article
[7] SPG 530, paras 17-22, 41, 128, 148. Back to article
[8] SPG 530, paras 53-60. Back to article
[9] Explanatory Memorandum for the Superannuation Legislation Amendment (Trustee Obligations and Prudential Standards) Bill 2012, para 1.18. Back to article
[10] SPG 530, para 56(c), (d) and (e). Back to article