Can Life-cycle Funds Be Life Savers?

Physician's Money Digest, April 2007, Volume 14, Issue 4

Life-cycle funds are a one-size-fits-all solution foryour retirement savings,which means that they donot really fit anyone perfectly.On the other hand, mostinvestors are likely to earn betterreturns over the years using life-cyclefunds for their retirement money thanthey will by managing their retirementportfolios on their own.

To understand why life-cycle fundsmay be a good choice for you, but stillmay fall far short of the ideal way tomanage your retirement money, let usstart by discussing what life-cyclefunds are.

Invest More, Spend Less

Life-cycle funds are based on thefollowing two basic tenets of retirementinvesting:

1. Investors can and should investmore of their retirement savings instocks when they are young because atthat time they can afford to take morerisk. And as they move closer to retirementand retire, the portfolio mix ofequity and fixed-income should be tiltedtoward fixed income.

2. Investors can significantly increasetheir expected long-term investmentreturns by keeping investment costs low.And a way of doing so is to use mostlyindex funds.

It is easy to understand how life-cyclefunds incorporate these two tenets bylooking at the example of Vanguard'slife-cycle funds, called Target Retirementfunds. Vanguard offers targetretirement dates at 5-year intervals. Ifyou are planning to retire around year2030, you will invest in their TargetRetirement 2030 fund. Right now themoney you invest in this fund will beallocated about 88% to equity and12% to fixed income. Of the 88%allocation to equity, about 71% will beinvested in domestic stocks throughthe Vanguard Total Stock MarketIndex fund, 10% to the VanguardEuropean Stock Index fund, 5% to theVanguard Pacific Stock Index fund,and 2% to the Vanguard EmergingMarket Stock Index fund. The 12%allocation to fixed income will beinvested in the Vanguard Total BondMarket Index fund.

Over the years the stock allocationwill be gradually reduced and the fixed-incomeallocation increased to ultimatelyreach an allocation of 30% to equityand 70% to fixed income around somewherebetween 5 years and 10 yearsafter retirement in 2030.

Because all of the money will beinvested in Vanguard's low-cost indexfunds, your annual investment costs willprobably be around 0.3%—a veryattractive, low number.

Cons to Keep in Mind

So should you rush and shift all yourretirement savings to such a life-cyclefund if you have the opportunity to doso? Not necessarily.

In these funds, you have no controlover the allocation between equity andfixed income over the years. If youwant to be more or less aggressive thanthe fund's underlying strategy, then youwill have to do it yourself by allocatingsome of your retirement money intoother funds on the side. That, of course,will defeat the simplicity advantage oflife-cycle funds.

Another consideration is that withinequity, you will probably be better offby allocating more money to smallercap and value stocks, but in most lifecyclefunds you will be stuck with atotal market index fund, which is heavilyweighted in large cap stocks andequally weighted between value andgrowth stocks. You may also prefer ahigher allocation to internationalstocks and to emerging market stockswithin that.

Finally, on the fixed-income side, youmay prefer to keep your average maturitiesat about 5 years, because studiesshow that you generally do not get compensatedfor the higher risk you take byinvesting in longer-term bonds.

The Bottom Line

  • Life-cycle funds are a one-size-fits-allsolution for your retirement savings,so they may not fit your needs perfectly.
  • Over the years the stock allocationwill be gradually reduced and the fixed-incomeallocation increased.
  • You have no control over allocation,and life-cycle funds are heavily weightedin large cap stocks.

Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at chandansen@aol.com.