PREPARING FOR RETIREMENT IN AN UNCERTAIN WORLD

April 6, 2010

Dynamic lifecycle investing involves individualized portfolio updating and adjustments each year, based on prevailing market conditions, changing investor expectations about future earnings and changes in the investment horizon.  Unlike conventional lifestyle accounts that are based primarily on a worker's age, the dynamic lifecycle strategy is responsive to market conditions that affect the current value of the investor's retirement account.  For example, during a bull market, the ratio of 401(k) assets to total wealth would rise, suggesting lower stock holdings are in order.  The converse would hold during bear markets, say Liqun Liu, Andrew J. Rettenmaier and Thomas R. Saving, economists with the Private Enterprise Research Center at Texas A&M University. 

In their study, Liu, Rettenmaier and Saving simulated portfolios using the earnings profiles assumed in the 2009 Social Security Trustees Report.  The simulated portfolios show that, on the average, dynamic lifecycle portfolios have a higher replacement rate than conventional lifecycle strategies for every level of risk. 

For example: 

  • The dynamic average replacement rate is 14 percent higher -- and its relative variation lower -- than a portfolio that is constantly invested 60 percent in stocks and 40 percent in bonds.
  • The dynamic account produces a 21 percent higher average replacement rate than an aggressive static lifecycle account (one that is weighted more toward stocks), but exhibits only slightly higher relative variation. 

Thus, appropriately chosen lifecycle investment strategies can take advantage of the average higher returns offered by the stock market, but with less risk.  On the average, as a percentage of lifetime wages: 

  • An account invested 100 percent in stocks offers the highest wage replacement rate (197 percent), but the coefficient of variation (a measurement of risk) is 27 percent.
  • An account invested 100 percent in bonds offers the lowest wage replacement rate (62 percent) and the coefficient of variation in replacement rates is only 6 percent.
  • By contrast, an account invested using a dynamic lifecycle strategy offers a wage replacement rate of 182 percent, which is only slightly lower than the all-stock portfolio, but the coefficient of variation is only 18 percent.
  • For individuals who want to minimize their risk, the baseline dynamic lifecycle account offers a 145 percent replacement rate, and a coefficient of variation that is only slightly higher than the all-bond portfolio, at 8 percent. 

The results of this study support a change in public policy to allow employers offering 401(k)s to default their employees into a dynamic lifecycle fund, say the economists. 

Source: Liqun Liu, Andrew J. Rettenmaier and Thomas R. Saving, "Preparing for Retirement in an Uncertain World," National Center for Policy Analysis, Study No. 328, April 6, 2010. 

For text:

http://www.ncpa.org/pub/st328

 

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