Life cycle funds are expanding beyond the
401(k) market to financial advisors.
Agrowing number of individuals who participate in a
401(k), 403(b), or employer profit-sharing plan are turning to life
cycle funds as a simple solution to building a diversified retirement
nest egg. According to Financial Research Corp., these funds managed
$90.8 billion in assets as of July 31, up from $14.5 billion at the end
of 2002. They could become even more popular as a default option in the
wake of new legislation that clears the way for employers to
automatically enroll workers in 401(k) and other defined contribution
As the market for life cycle funds in company plans heats up, sponsors are pitching them to financial advisors as a simple and effective alternative to assembling a portfolio of funds or individual securities, particularly for smaller investors and business or professional retirement plans. "We are proactively expanding our distribution in the intermediary space," says Tim Kohn, a defined contribution retirement plan specialist at Barclays Global Investors. "They are easy to explain and they offer a complete, one-stop solution."
Kohn says advisors often use the funds for small business or professional office 401(k) and defined contribution retirement plans, which sometimes designate them as a default option when participants don't make their own choices. "But these aren't just for businesses and they are not just for retirement," he says. "They can be used for education planning, or any other event that you can predict a specific need at a specific date." Although the bulk of assets invested in Barclays LifePath funds go into the 2010 and 2020 portfolios, geared for those drawing in on retirement, Kohn has seen "huge acceptance by younger individuals."
Also called target date funds, life cycle funds allocate assets into different fund baskets based on specific retirement years, such as 2010, 2015 or 2030. The initial mix, which may include stock funds, bond funds and perhaps real estate or international funds, shifts to more conservative allocations as retirement approaches and usually becomes even more conservative after the target date passes.
But these funds also have some obvious drawbacks. They don't take into account individual circumstances, such as whether someone plans to retire early, wants to leave an inheritance or has other sources of retirement income. They may not include asset classes with a strong negative correlation to the stock market, such as commodity or currency funds. And they usually tie investors down to using just one fund family across all asset classes.
Kohn says advisors can tailor investment strategies to a certain extent by using life cycle funds as a core holding, then building satellite funds around them according to a client's individual circumstances. "These funds are like shirts that come in small, medium and large sizes," he says. "They aren't going to fit everyone. But they will fit about 80% of people."
There is also the thorny question of a potential conflict that arises for advisors who view asset allocation, fund selection and portfolio rebalancing as a key part of their service that cannot be replicated. "The biggest objections we get are from advisors who believe they shouldn't be offering a fund that does something they think they're supposed to do," says Matt Mincer, managing director at AllianceBernstein. "But using more funds and more complex investment strategies hasn't gotten many people to where they want to be. A single source investment solution allows the focus to shift to helping their clients with other issues. It's really a question of whether an advisor wants to turn a key and start the car, or be the mechanic responsible for the engine."
Not everyone wants to be a mechanic. Mark Ferris, an advisor in Old Saybrook, Conn., who has used life cycle funds for accounts as small as $5,000 and as large as $1 million, views his role as "handling a client's bigger picture. If I'm spending all of my time rebalancing portfolios and deciding which funds to invest in, that leaves less time for me to talk about important issues like changing jobs, funding college, or paying for a child's wedding."
Ferris says the despite their pre-cast asset allocations, life cycle funds allow for some planning leeway. One way he is able to accommodate individual circumstances, for example, is selecting the target date based on when someone needs to begin spending down the account, not their anticipated retirement date. But he doesn't use them for clients who have other sources of income at retirement and are unlikely to touch the money, since the asset allocations dictated by the funds may be too conservative for such individuals.
Others advisors, like Gary Williams of Williams Asset Management in Columbia, Md., generally craft customized portfolios but use life cycle funds on a limited basis. "I might recommend them if an existing client who meets my minimum account standard is starting a Roth IRA with a few thousand dollars," he says. "They're a great way to get instant diversification. But I really think they're a niche market for smaller accounts. My question is why someone would need a financial advisor to use a plug-and-play solution."
Sponsors contend life cycle funds serve a purpose beyond the four-digit account market. "I think it's a misconception that target date funds are only for small investors," says Mincer, who views the rollover market as fertile ground for the prospects. "People in their fifties and sixties are often looking to consolidate their assets and get on the right track for retirement. These funds are great for them."
Tim Noonan, managing director of U.S. individual investor services at Russell Investments, believes life cycle funds "offer a streamlined solution, especially for accounts under $200,000, which is considerably bigger than the typical retiree nest egg. They're a huge boon to an underserved segment of investors."
Noonan has seen advisors put children or family members of clients with substantial accounts into life cycle funds when they don't have the required minimum account size for their practices. "They are also being used as a way to rationalize books, especially in the broker-dealer channel," he says. "If profitability is hitting a wall someone might segment their book into different service tiers. Life cycle funds are an effective way to service the less profitable tiers."
Evaluating The Options
Advisors considering using target date funds, whether on a limited or for a broad swath of clients, need to consider a number of features. About two dozen fund companies offer them, but because most are less than three years old they don't have longer-term track records. Beyond the individual funds are some other factors to consider:
Asset allocations. Because the funds allocate assets differently, both initially and as they move toward their target date, it is likely that long-term performance will vary widely from one fund to another.
Fund companies typically plug portfolio optimization strategies into their asset allocation models that take into account a variety of factors, including risk/return profiles for the different asset classes. While all of them gradually move toward more conservative investments as retirement approaches, they may start out with different allocations and change them at different rates. Fidelity Freedom Funds 2020 portfolio has a 69% allocation toward stocks with the rest in bonds. T. Rowe Price's Retirement 2020 Fund has about an 80%/20% mix of stocks to bonds, while Vanguard Target Retirement 2020 Fund has a 73%/27% split.
Even if the mix of stocks to bonds appears similar, the components within each asset class can vary among offerings. Some may invest more heavily in aggressive small- and mid-cap growth stocks on the equity side, for example, or take a more conservative approach for the bond component with short duration funds. Others may put greater emphasis on international or emerging markets.
The equity "landing point." The percentage of assets allocated toward equities at the target date and afterward also varies. Russell's LifePoint funds provide a ratio of 40% stock funds and 60% bond funds allocation at the target date, gradually falling to an ultimate 20%/80% mix 20 years afterward. AllianceBernstein starts the target date with 55%/10%/35% mix of stocks, real estate investment trusts and bonds, and moves to a mix of 25% stocks, 10% real estate investment trusts, 37.5% bonds and 27.5% short duration bonds 15 years after the target date. The equity allocation at American Century's offerings falls to 45% at the target date and does not change during the holding period.
Expenses. Funds with more aggressive investment strategies, including those with more distant target dates, will typically have higher expense ratios than more conservative ones because they are stocked with costlier equity investments. Among fund companies expenses can vary widely. Some charge a management fee in addition to the costs associated with the underlying funds, while others, such as Vanguard, do not.
Target date intervals. Some programs offer funds only at ten-year internals, while others, including T. Rowe Price, Fidelity and Alliance Bernstein, offer them in five-year increments that allow for more precise planning.