Lifecycle funds are becoming popular, but some think their use is limited.
Investing doesn't get any easier than lifecycle
funds, at least on paper. The basic concept is enticing-invest in a
fund with a predetermined asset allocation based on your desired risk
tolerance or expected retirement date, sit back, and let the fund
managers make the appropriate allocation decisions for you. No fuss, no
muss.
Considering the appeal of prepackaged asset
allocation, it's little wonder that lifecycle funds are one of the
hottest areas in the mutual fund industry. According to Lipper, assets
in this category have more than doubled since 2000, fueled in large
part by their growing popularity among 401(k) providers. Fifty-five
fund companies offered lifecycle products as of the end of last year,
including such heavyweights as Fidelity Investments, The Vanguard Group
and T. Rowe Price.
These investment vehicles go by a gaggle of names,
such as lifecycle, lifestyle, target-date, target-risk,
target-retirement and target-allocation funds. Lifecycle is the general
catchall term, however. Despite their growing popularity, lifecycle
funds aren't right for everyone, and that includes financial advisors.
"Some advisors like them and some don't," says Eric Tashlein, a
certified financial planner and principal at Connecticut Capital
Management Group in Milford, Conn. "I guess I fall somewhere
in-between."
Many advisors like the turnkey approach of lifestyle
funds because it gives them time to focus on other areas of their
practice beyond managing investments. But other advisors question their
costs and the "commoditization" effect they have on the profession.
Lifecycle funds come in two flavors: those with
portfolios built around specific retirement dates, and those built
around specific asset allocations. Although some lifecycle portfolios
are comprised of individual securities, the majority are fund of funds
spread across various equity, fixed-income and money market assets.
Funds based on specific allocations are called
target-risk or lifestyle funds. These run the gamut from conservative
to moderate to aggressive portfolios, and they enable people to invest
based on their risk profile at a given point in their life. According
to conventional wisdom, a 25-year-old person should invest in an
aggressive portfolio that's top-heavy in equities. Because target-risk
funds essentially maintain the same allocation mix over time, that same
investor should rotate into a less-aggressive fund when they reach
middle age. Older investors, or the very risk-averse, should stick with
conservative allocation mixes with greater fixed-income bents.
Financial Research Corp. in Boston reports that
target-risk funds control more than 65% of total lifecycle fund assets.
But target-date funds, or those with portfolio mixes pegged to specific
retirement dates, are the faster-growing segment, thanks to their
proliferation in the 401(k) market.
Target-date funds carry self-explanatory names such
as the Barclays Global Investors 2010 fund or the Principal Investors
Lifetime 2020 fund or the Wells Fargo Outlook 2040 fund, with the years
indicating specific retirement dates. The further out the date, the
greater the equity mix. These funds automatically rebalance their
portfolios toward more conservative allocations as they go through time
and draw closer to their specified retirement year. Beyond that point,
many eventually convert into fixed-income-oriented funds designed to
last another 20 to 30 years.
Different fund companies employ different allocation
mixes within the same target date. The Vanguard Target Retirement 2035
portfolio is 77% invested in stocks, according to Morningstar. In
comparison, stocks comprise 82% of the Fidelity Advisor Freedom 2035
fund and 89% of the T. Rowe Price Retirement 2035 fund.
T. Rowe Price's lifecycle funds are among the
industry's most aggressive. The company's philosophy stems from
extensive math modeling and studies of such factors as withdrawal
rates, time horizons and various asset allocation mixes between
equities, fixed income and cash, in 5% increments.
"We concluded that the biggest risk to investors is
outliving their assets," says Jerome Clark, portfolio manager of T.
Rowe Price's retirement funds. "Investors need an opportunity for
enough capital appreciation to combat inflation and maintain purchasing
power."
The company's M.O. is evident in their target-date
funds, both before and after they reach their target maturity date.
Most other fund companies combine their lifecycle funds with an income
fund five to ten years after the target date is reached. T. Rowe Price
favors keeping investors in their original fund for 30 years after the
retirement year is reached, eventually whittling down their equity
portion from 55% to 20% toward the end.
The professionally managed autopilot approach to
lifecycle funds is finding a home among defined contribution plans,
where horror stories abound about self-directed individuals butchering
their retirement portfolios through lack of knowledge and poor
decisions. A 2003 survey by Hewitt Associates found that 55% of plan
sponsors offered lifecycle funds in their 401(k) plans versus 35% in
2001. Roughly one-third were in target-date funds.
With their asset-in-a-box approach, lifecycle funds
are meant to be stand-alone investments. Too much diversification
outside of these funds can muddy up the allocation picture for some
investors. "There can be a lot of redundancy that screws up the
appropriate allocation mix for their age," says Ross Frankenfield, an
analyst with Financial Research.
But if properly managed, lifecycle funds can provide
a degree of diversification that most small retirement accounts
couldn't get otherwise. "I think they're great for novice investors
because it gives them a disciplined approach that covers the broader
market," says Tashlein from Connecticut Capital Management, who as part
of his overall practice advises a handful of companies on their
employee 401(k) plans. "I review a number of 401(k)s from individuals
who chased after hot funds and ultimately would've been better off with
the happy-meal approach."
Tashlein limits his use of lifestyle funds for these
401(k) clients, as well as for his private clients with 529 plans that
generally comprise just a small portion of their overall holdings. Some
plans, such as the American Funds, have age-based lifecycle features
that change allocations as the child approaches college age. "Rather
than me spending a lot of time reallocating this small account," he
says, "this fund does it automatically."
But Tashlein cautions that some investors get a
false sense of security from these funds. "Some of these portfolios
tanked 40% or more during the downturn, so they're certainly not a sure
thing," he says.
Gauging lifecycle fund performance isn't easy,
partly because most haven't been around very long and also because they
have varying allocation strategies that make comparisons difficult.
"The best way to gauge lifecycle funds is to analyze the underlying
fund of funds and compare those that are style- or sector-specific
against their peer groups," says Lipper analyst Lucas Garland.
That might be doable for a Vanguard fund with just a
few underlying index funds, but try doing that with a Fidelity Freedom
fund comprised of up to 18 underlying Fidelity funds. Given the
diversity of funds underpinning many lifecycle offerings, some become
so broadly allocated that they essentially become index funds that more
or less track the market. For some advisors, that doesn't justify the
cost of these offerings.
"I'll pay for management when it brings value," says
Michael Scarborough, president of The Scarborough Group in Annapolis,
Md. "I'm not going to pay for management of index funds when I can use
iShares."
Lifecycle fund fees can vary. Investors pay the pro
rata fees associated with the underlying funds, which isn't a huge bite
if it's with a low-cost fund company. But some companies charge an
additional fee for management and other expenses associated with the
actual lifecycle fund, and fees tacked onto advisor-class shares bump
up costs even more. Meanwhile, frequent portfolio rebalancing can rack
up capital gains distributions unless the funds are in tax-advantaged
accounts.
Scarborough, whose firm provides actively-managed
401(k) accounts for individual investors, says he adds value for his
clients by creating lifecycle-type accounts at less cost than those
provided by mutual fund companies. "What's happening is that the big
fund companies are turning everyone in my industry into a commodity,"
he says. "Everything is boiling down to a price point. You have to know
how to manage money, not just how to sell something."
The flood of new products probably won't abate any
time soon. More than 80 new lifecycle funds were introduced last year,
bringing the total to 244 as of year-end 2004. Fidelity is the category
leader, with 30 lifecycle funds and total assets of $33 billion as of
February. The fund giant has a whopping 70% market share in the
target-date category, and is slightly trailing Vanguard's 18% market
leadership in the target-risk segment.
Fidelity, T. Rowe Price and others are stepping up
marketing efforts through the advisory channel, and that's fine for
some advisors. "I feel liberated by lifecycle funds," says Mark Ferris,
a certified financial planner at Yankee Cents Financial Services in Old
Saybrook, Conn.
Ferris says he used to be the de facto lifecycle
fund manager for his clients, but now puts many of his clients into
target-risk portfolios from among either the Gartmore Optimal
Allocation or J.P. Morgan Investor funds, or in target-date funds from
Fidelity. "Using these funds allows people in our profession to focus
on financial issues with clients, beyond the stock market," says Ferris.