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Are life cycle fund investors doing it wrong?

Life cycle funds that are becoming increasingly popular are meant to make retirement planning easy. But that’s not how investors have been using them.
/ Source: The Associated Press

Life cycle funds that are becoming increasingly popular are meant to make retirement planning easy. But that’s not how investors have been using them, mutual fund companies say.

The funds are aimed at a specific retirement year. Fidelity Investments’ life cycle Freedom Funds for instance, start with a fund for people who retired before 1998, then progress to a fund for people who plan to retire in 2050.

The funds are an aggregation of many other mutual funds, sometimes as many as 25. The idea behind life cycle funds is that investors tend to do a poor job of diversifying and rebalancing their portfolios as they approach retirement, so the fund will do it for you, starting with an aggressive mix of equities and bonds in the decades before retirement and rebalancing, often daily, to maintain diversification.

The funds become more conservative as retirement nears, selling stocks and buying bonds; they’re meant to be an all-in-one solution for retirement, offering complete diversification in a single fund.

248 percent growth over 3 years
It’s an idea many investors have found appealing. In 2004, the last year for which numbers are available, about six in 10 employer plans run by The Vanguard Group Inc. offered life cycle funds. Fidelity’s Freedom line of life cycle funds have grown 248 percent over three years, to $45.9 billion as of Jan. 31.

The problem, according to the Vanguard study, “How America Saves 2005,” is that while the funds offer complete diversification in one investment vehicle, “actual participant behavior is at odds with this goal, with many participants using life cycle funds as just another part of their overall portfolio.”

The larger problem is that people continue to do really foolish things with the rest of their portfolios. Vanguard found in its study that 13 percent of participants in its defined contribution funds had their entire accounts in fixed-income securities and 21 percent held all-equity portfolios. Forty-four percent of participants in plans that offered company stocks held concentrated holdings exceeding 20 percent of their account balances. The big idea behind life cycle funds is that they are one way to save investors from themselves.

But that doesn’t appear to be happening. Vanguard found that 29 percent of people who invested in the funds as part of their company’s retirement benefits used the funds as intended, as an all-in-one investment. Another 49 percent invested in a life cycle fund and one or more stock funds.

‘Naive approach’
The third group of life cycle fund investors appears to take what Vanguard calls “a naive approach,” investing in multiple life cycle funds. In 2004, 22 percent of Vanguard participants with access to life cycle funds owned multiple life cycle funds and some also invested in other funds, too.

One possible explanation is that participants view the life cycle funds as a low-risk option, Vanguard’s report said. Another explanation is that participants don’t understand the diversity of holdings in a single life cycle fund, so they buy funds with multiple retirement dates in an effort to diversify.

“Ironically, one of the principles of sound investing that Americans have taken to heart may also pose a hurdle to life cycle funds: the notion that one should never ‘put all their eggs in one basket,’ ” a description of the funds on Fidelity’s Web site said. “With additional education, investors should be able to understand that this clearly doesn’t apply to a life cycle fund that may include dozens of underlying mutual funds holding hundreds or even thousands of individual securities.”

The problem, as Fidelity explains it, is that “life cycle investing can only really do the job for investors if it is used as the core strategy for most of the assets being earmarked for a given goal. Allocating a small portion of assets to a life cycle investment program will neither provide the diversification nor the age-appropriate risk exposure that is so critical to this way of investing.”

Fidelity’s advice for investors in life cycle funds is to invest the bulk of their assets in a fund targeted for their retirement group, then use the small portion left to play with.

Consider a mutual fund tracker
If you’re investing in a life cycle fund through your 401(k) at work, you may have only one family of funds to pick from. But if you’re looking into mutual funds independently and you’re interested in life cycle funds, its worth considering a study by mutual fund tracker Lipper that came out late last month. Lipper studied life cycle funds from AllianceBernstein, Fidelity, T. Rowe Price and Vanguard.

The companies’ life cycle funds used stocks, bonds, as well as, in some fund families, cash, inflation-protected securities and real estate investment trusts. Using a simulation of the companies’ different allocation schemes, how each is expected to change over a life cycle fund’s lifetime and 40 years of market returns, the simulation found that AllianceBernstein’s offering was the leader.

One of Lipper’s theories why AllianceBernstein’s funds did so well in simulation: They included fewer investment classes in their allocation scheme. In short, their allocations were simpler.

If you’re reading this, you may be sophisticated enough as an investor that you don’t need the simplicity of a life cycle fund. But if you know anyone who is making any of the classic mistakes — too much company stock, buying only stock funds, or putting everything into an asset class that has already peaked — the idea of putting almost everything in a life cycle fund, then playing around with the change may be a simple solution that makes sense.