Life-Cycle Funds Prosper as People Work Longer

It didn't reach the "irrational exuberance" level on the Alan Greenspan Richter scale, but the Federal Reserve chairman has been causing minor quakes among baby boomers with his recent comments about the nation's "overcommitted" Social Security system.

If Congress does bite into that safety net, it would force an entire generation to rethink its retirement plans, especially those who have already chosen the year they intend to jump out of the workforce.

Boomers looking to retire in 2010 might have to wait until 2015. The 2015 set will shift back to 2020. And so on.

Those retirees who developed their retirement plans by working backward from a future date might need to realign not only their calendars, but more importantly, their asset allocations.

The typical back-of-the-envelope calculation for allocating an asset mix according to one's age has always been to subtract your current age from 100 and invest the difference in stocks. So if you're 40, the quick math would lead you to an asset allocation of 60% stocks, 40% bonds.

A sneak peek into life-cycle funds, however, might offer a more detailed asset allocation for people who want a quick assessment about whether their asset breakdown matches their target retirement date.

Life-cycle funds have been around for over a decade for investors looking to invest on autopilot. Instead of annual or biannual meetings with a financial adviser to discuss asset allocation in a portfolio, the life-cycle fund portfolio manager reallocates for the entire fund on the basis of a specified retirement target year.

"Life-cycle funds can be effective for investors who want to take a hands-off approach to investing," says Lipper analyst Jeff Tjornehoj. "But they are difficult to use as part of a portfolio, because they overlap with other funds or asset classes. It's an all-or-nothing product."

Something for Everyone

That all-encompassing quality makes life-cycle funds a popular investment for investors who are just getting started, and they also provide an opportunity for an experienced investor to get a quick second opinion on his or her own portfolio.

And unlike a yearly financial checkup at the financial adviser's office -- which many people postpone much like a dental appointment -- life-cycle funds are continually updated by professionals.

For example, Barclays life-cycle funds specialist Tim Kohn says the company monitors each of its life-cycle funds on a daily basis and fine-tunes their respective asset allocations up to 15 times per year.

For those looking to graduate from the workforce in the classes of 2010, 2020, 2030 and 2040, the most popular life-cycle funds break down their assets as follows in table 1.

Those Boomers looking for an asset allocation for a year that ends in a "5" need not worry. Vanguard's life-cycle fund offerings can serve as a guide, as seen in table 2.

Life-Cycle Fund Asset Mix
For those retiring between 2010 and 2040
Fund Retirement Date Ticker Stocks Bonds Cash YTD Return (as of 3/10) Expense Ratio
Barclays Global Inv. 2010 STLBX 47% 52% 1% 1.87% 1.1%
Fidelity Freedom 2010 FFFCX 47.4 43.5 8.8 1.84 0.81
T. Rowe Price 2010 TRRAX 67.2 27.9 4.9 1.78 0.72
Barclays Global Inv. 2020 STLCX 61.7 38.3 0.8 2.05 1.1
Fidelity Freedom 2020 FFFDX 71.4 28.6 0 1.77 0.88
T. Rowe Price 2020 TRRBX 78.3 16.9 4.8 1.71 0.81
Barclays Global Inv. 2030 STLDX 72.5 26.1 1.4 2.34 1.1
Fidelity Freedom 2030 FFFEX 82.9 17.1 0 1.62 0.91
T. Rowe Price 2030 TRRCX 89.2 6.2 4.6 1.59 0.85
Barclays Global Inv. 2040 STLEX 84 15 1 2.07 1.1
Fidelity Freedom 2040 FFFFX 89.7 10.3 0 1.59 0.94
T. Rowe Price 2040 TRRDX 89.3 6.1 4.6 1.59 0.85
Source: Company Websites/Morningstar

Life-Cycle Fund Asset Mix
For those retiring between 2005 and 2045
Fund Retirement Date Ticker Stocks Bonds Cash YTD Return (as of 3/10) Expense Ratio
Vanguard Target 2005 VTOVX 34.66% 64.83% 0.51% 2.91% 0.23%
Vanguard Target 2015 VTXVX 49.65 50.01 0.34 2.59 0.23
Vanguard Target 2025 VTTVX 59.71 40.1 0.19 2.47 0.23
Vanguard Target 2035 VTTHX 79.53 20.03 0.44 2.35 0.23
Vanguard Target 2045 VTIVX 89.4 10.01 0.59 2.24 0.23
Source: Company Websites/Morningstar

As shown in the table, T. Rowe Price maintains a heavier equity weighting for its life-cycle funds compared with its competitors. T. Rowe Price portfolio manager Jerome Clark explains that his firm's aggressive equity allocation is a function of "a great deal of math modeling."

He also says T. Rowe's overweighting in equities is partly a function of an ever-increasing American life expectancy.

"In our models we use a retirement age of 65, a 30-year postretirement time horizon and an average life expectancy of 83. It might seem high, but 23% of people are living past the age of 90 nowadays," says Clark. "And the trend is moving up."

The other major assumption in the T. Rowe Price model is a 4.5% initial withdrawal rate, which Clark calls conservative on the basis of a May 2003 T. Rowe Price study.

The study said that for current retirees withdrawing funds each year from their portfolio, the probability of outliving retirement resources reaches its lowest level when initial withdrawal rates were kept below 5%. And with a 4.5% initial withdrawal rate, the probability bottomed out with portfolios consisting of 40% stocks and 60% fixed income over a 30-year time horizon.

Jack Ladley, actuary and senior partner at Ernst & Young, confirms the findings of the T. Rowe Price study on withdrawal rates, but he warns future retirees against the risks of simply waiting for the magic year to arrive.

"You want to be thinking about your asset allocation three to five years before your retirement date," says Ladley. "Remember what happened to the retirees from the class of 2000-2001? The bear market forced them to change their plans quickly."

John Sweeney, product manager for Fidelity's Freedom life-cycle funds, says investors should not expect life-cycle funds to correspond to the exact year of their retirement.

"I don't think there's a need for single-year life-cycle funds like 2021's or 2022's. You get the most benefit of the asset allocation in a five-year period," says Sweeney.

Current retirees unfortunately will have difficulty using life-cycle funds as an asset-allocation benchmark. Once the target date is reached, most life-cycle funds merge into a static income fund. In Fidelity's case, Sweeney says the Freedom funds usually end up with a 40% equity position by their target date, which is then rolled down to 20% after seven years before it finally merges into the Freedom Income fund.

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