Life-cycle funds have been revered by both asset managers and the press as a panacea for struggling retail investors who could die paupers come retirement. But like every investment product, these funds come with their fair share of caveats.
Life-cycle funds are built on the premise that we are historically bad at creating a diversified portfolio and lazy about rebalancing, so these products do it all for us.
The age-based portfolios, also called target-date funds, are to be held until a specific retirement year. They begin with an aggressive mix of stocks and bonds, and then are professionally rebalanced to maintain diversification and limit risk going into retirement.
These funds are most often presented as a happy medium between the defined-benefit plan of old and the freedom of a defined-contribution plan like a 401(k) or IRA. Investors get a portfolio they never have to think about until retirement. Moreover, because the funds follow the strategies created by a specific asset management company, they essentially deliver investment advice through a product.
The funds recently have been in the spotlight because of the
pension reform bill that passed last month. The new rules allow companies to begin
automatically deferring employee earnings into 401(k) accounts. Under these plans, life-cycle funds could be the default option -- in fact,
T. Rowe Price
says about two-thirds of its clients who automatically enroll employees use target-date funds as their default.
But before jumping into an all-in-one life-cycle fund, there are a few drawbacks to note.
Because life-cycle funds are designed to be stand-alone offerings, investors could have a difficult time allocating the rest of their money.
"The life-cycle fund is only picking for your 401(k), and you have to look at all of a person's assets," says Lewis Altfest, president of financial planning firm L.J. Altfest & Co. A person may have all equity stocks or funds outside of his or her pension, so to pile on equities with a life-cycle fund may not be appropriate."
The problem also emerges when the life-cycle date funds are held in conjunction with other retirement products.
"For example, if you've maxed out your 401(k) and have an IRA, what should you own in that account that won't overlap with your life-cycle fund? It's very hard to know," says Greg Carlson, a Morningstar fund analyst who covers life-cycle funds.
According to Vanguard research, life-cycle funds are being misused by many investors who own them. In its report
How America Saves 2005
, the fund giant reiterates that life-cycle funds are meant to take care of all of an investor's needs by providing complete diversity and rebalancing, but that "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 study found that only 29% of people who invested in these funds as part of their company's retirement benefits used them as an all-in-one investment. About 49% invested in a life-cycle fund and one or more stock funds, and 22% of life-cycle fund investors even owned more than one life-cycle fund.
Eggs in One Basket
Vanguard's finding isn't surprising given that putting investment dollars in just one product causes well-earned shudders among those who have been burned by such a strategy.
"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,'" Fidelity says on its Web site. "With additional education, investors should be able to understand that this clearly doesn't apply to a life-cycle fund."
But while life-cycle funds boast diversity as their best attribute, they're still composed of a single company's funds.
"Vanguard has good funds and it has underperforming funds. So does Fidelity and every other management company. But Vanguard is never going to say, 'Our funds haven't done well. We're going to recommend some T. Rowe Price funds for you'," says Altfest. "Why not pick from the best of the best ... Why limit yourself to the diet of any one company?"
Carlson says costs can also be an issue with life-cycle funds. While Vanguard's index-based products charge fees around 0.25%, Wells Fargo has products that charge as much as 1.25%.
"For a fund investing in stocks and bonds, that's somewhat on the high side," Carlson says. "These are designed to be held for decades, so the higher costs will really cut into your holdings."
Altfest says you're paying more for convenience, which is not necessarily a bad thing. "People go to
knowing they can get a better quality and better tasting burger somewhere else, but they want the ease."
Know Thy Master
Asset allocation for the same target date varies from company to company, and there are philosophical differences when it comes to how much of the fund should be based in stocks instead of other asset classes.
In order to choose a fund that matches their investment personality and risk tolerance, investors have to know what the asset allocation is and how it changes over time.
Since these funds offer diversification across a broad range of stocks and bonds, the fund companies need to have a pretty broad-based expertise in order for the funds to be attractive.
Not every shop has that breadth of fund offerings, which is one reason why life-cycle funds have come from big names like Fidelity and Vanguard. If smaller companies start to roll out life-cycle funds, they should be carefully checked to make sure that their existing funds cover a lot of fund styles and that they've performed relatively well.
"People are talking about target-date funds because it is a timely story ... but a vast majority of these products are less than three years old. They're a growing presence in 401(k) plans, but we can't truly judge their performance yet," says Carlson.