Lifecycle funds: the pros and cons of saving on autopilot
Investing in today’s market and building a retirement portfolio can be tricky business. Many people choose to make a regular contribution to their company’s 401(k) plan and simply let it sit there. Although there might be good reason to leave things just as they are, many investors don’t take the initiative to monitor their portfolio and modify allocations or reduce risk potential as they near retirement. The truth may be that people are not certain exactly what they should do — so they do nothing, and that decision could potentially be a harmful choice when it comes to long-term return on investment. Looking for clear advice and one-stop shopping, investors are increasingly turning to automatic saving options.
As people continue to embrace ready-made diversification and simplification, more financial institutions are including lifecycle or lifestyle funds as a part of their offerings. Lifecycle funds (also known as age-based funds or target-date funds) were first introduced in the ’90s, but have recently become a commonly used investment strategy.
The August 2006 Investment Company Institute and Employee Benefit Retirement Institute Participant-Director Retirement Plan Data Collection Project showed that lifecycle/lifestyle funds have grown in popularity among investors and retirement plan sponsors. In 2005, investors held $167 billion in lifecycle/lifestyle funds, a 245 percent increase over just two years ago. The funds are increasingly being offered as investment alternatives in 401(k) plans.
What are lifecycle funds?
Designed to make retirement investing easier by automatically shifting your funds to match your stage of life, lifecycle funds offer investors a pre-mixed set of stocks, bonds and cash according to age and risk tolerance. They are based on the idea that asset allocation is the key to long-term investment success. The common belief is that stocks are riskier than bonds, yet offer potential for higher returns. Therefore, most professionals recommend that younger investors hold most of their investments in stocks and slowly shift to bonds as they approach retirement — the assumption being that investors with a longer time horizon for investment can tolerate higher risk. Lifecycle funds follow this theory by first growing, then preserving investments as the investor moves close to retirement.
There are two types of lifecycle funds: target-date and target-risk. Target-date funds tie the asset allocation mix to a specific retirement date. The funds automatically adjust based on the number of years until the investor’s expected retirement. Target-risk funds are divided into groups based on level of risk, usually aggressive, moderate or conservative. It is the individual investor’s responsibility to shift his or her assets as needed.
Why consider lifecycle funds?
Through automation and simplification, lifecycle funds offer a one-step solution for those investors who don’t want to fuss with diversification or rebalancing. It puts the responsibility for identifying and maintaining a proper asset allocation into the hands of professionals. All the individual has to do is decide which fund is a best fit based on his or her individual situation and leave the rest to the experts.
What are the potential drawbacks?
Although lifecycle funds may be a good investment tool for some people, there are a few things to consider before you sign on. Most lifecycle funds use age as the overriding factor when determining how to allocate your funds; however, the risk profile of every individual is not necessarily a one-dimensional factor of age. Not everyone who is 40 years old has the same capacity or tolerance for risk. Even among investment companies, the stock/bond split for funds targeted to the same retirement date can vary significantly.
Additionally, lifecycle fund managers assume this is the investor’s only account when making asset allocation decisions. If an investor holds additional retirement accounts the asset allocation of the complete portfolio may be out of alignment with the goals of the lifecycle fund, unless the investor is periodically rebalancing his or her other accounts. It is important to consider whether a lifecycle fund would be a good fit with your current holdings.
How should you evaluate lifecycle funds?
As with any investment decision, it is important to do your homework and evaluate your options carefully. First, find a fund that meets your overall risk tolerance as well as your financial goals. Most lifecycle offerings are funds of funds, meaning they invest in a range of offerings from the same fund family. Consequently, the lifecycle fund is only as good as its underlying investments. Do some research and look for experienced managers, a good performance history, and reasonable costs.
Because lifecycle funds are meant as a long-term strategy, costs play a crucial role in your total return. You will usually pay the fees charged for the underlying funds; in addition, some companies charge a fee on top of that for pulling the lifecycle fund together. It is important to pay special attention to any fees involved with the funds you are considering.
The fact is that managing a retirement account can be challenging. Knowing when and how to rebalance your portfolio isn’t always easy. For those who are looking for an automated, easy-to-use retirement savings vehicle, a lifecycle fund may be one solution. Each individual situation is unique and a professional financial planner can help determine the best strategies for reaching your goals and maintaining financial security throughout retirement.
This information is provided for informational purposes only. The information is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor.
