Even though the investment industry might have you think otherwise, investing for your retirement does not have to be difficult. Still, many people turn to investment advisors for help. Unfortunately, because of how advisors are compensated, there may be conflict between what is best for them and what is best for their clients. Life-cycle funds offer a viable solution. Here we'll examine what these funds are, compare different ones and finally look at some issues to consider before using these funds for your retirement portfolio.
What Are Life-Cycle Funds?
Life-cycle funds are the closest thing the industry has to a maintenance-free retirement fund. Life-cycle funds, also referred to as "age-based funds" or "target-date funds," are a special breed of the balanced fund. They are a type of fund of funds structured between equity and fixed income. The distinguishing feature of the life-cycle fund is that its overall asset allocation automatically adjusts to become more conservative as your expected retirement date approaches. While life-cycle funds have been around for a while, they have been gaining popularity. Many 401(k) plans in the U.S. offer them.
To get a better understanding of how these funds work, let us look at the Vanguard Target Retirement 2025 Fund. This fund targets people who aim to retire within five to 10 years of 2025. As of Feb. 29, 2011, the asset mix for this fund was as follows.
Differences: Fidelity Vs. Vanguard
While all life-cycle funds are similar in concept, they can be structured and maintained differently. When shopping for a life-cycle fund there are some important factors on which to compare different funds. To help determine which is best for you, we compare Fidelity and Vanguard - the two largest suppliers of these funds. Both have different management styles for their funds.
Fidelity offers actively managed funds, while Vanguard uses passively managed funds. Both these styles suit and appeal to different kinds of investors, but our point here is that the fee difference can be material. For example, Fidelity Freedom 2025 has an expense ratio of 0.73% while the Vanguard Target Retirement Fund 2025 has an MER of 0.18%. That equates to a difference of $550 per year for every $100,000 invested.
Also note that Fidelity has built in an additional 0.10% annual annuity charge, while Vanguard has not. In other words, the investor in Fidelity is hit with two expense ratios. When you decide to invest in a more expensive fund, do be sure to determine whether the higher costs are worth it. That is, ask yourself if the fund with higher costs is likely to render returns beyond what you would save by going with a cheaper fund.
Vanguard and Fidelity also differ in the number of underlying funds they use. Fidelity uses 23 underlying mutual funds and Vanguard uses three. This difference is partly a result of the way the funds are benchmarked: Vanguard's index funds are benchmarked against some of the broadest indexes available, covering a broader part of the market. For example, the Vanguard Total Stock Market Index Fund's benchmark is the Wilshire 5000 Index, which represents 5,000 publicly-traded companies in the U.S. The funds within the Vanguard Total Stock Market Index Fund together hold nearly 4,000 of those stocks.
Fidelity, like most U.S. equity funds, however, benchmarks against the S&P 500, which holds 500 of the largest publicly-traded companies in the U.S. To reach the same level of diversification as Vanguard Total Stock Market Index Fund, the Fidelity life-cycle fund needs to add small- and mid-cap funds, increasing its number of underlying funds.
Another factor to note that is especially important for retirement planning is a life-cycle fund's attention to inflation, which implies maintaining, to some degree, a position in equities. Vanguard also addresses the need to protect the principal of some of its bond assets from inflation with inflation-protected securities, a bond fund category that seeks to keep a fixed-income investment's principal from being eroded by inflationary impacts.
While these funds are a convenient option for many retail investors (i.e., one-stop shopping along with long-term, no-hassle portfolio management), they are not a solution for everyone - the same asset allocation is not necessarily applicable to everyone at a certain age. As the comparison above shows, mutual fund companies themselves don't agree on what the correct asset allocation should be for someone retiring in 2025. Getting counseling from a fee-based financial planner (who may be more objective because of his or her impartial compensation) might be a better solution for some investors who want to ensure that their portfolio's asset mix is appropriate for them.
Also, life-cycle funds only make sense if the vast majority of your retirement funds are in only one of these funds. Adding anything else could alter your overall asset allocation and contravene the whole premise of investing in life-cycle funds.
Finally, the future growth of life-cycle funds will really depend on their acceptance by the investment advisory community. Given their simplicity, many advisors might feel threatened because their clients may perceive that they are no longer adding any value. Their clients might ask themselves, "Why do I need a pilot for my retirement portfolio, when I can put it on autopilot?"
The Bottom Line
Life-cycle funds have gained popularity for their convenience and simplicity - something that can be tough to find from some investment advisors. Many retail investors are overwhelmed by the responsibility of managing their retirement portfolio and by the bewildering number of investing options facing them. Life-cycle funds make like easy for investors seeking a solution that delivers simplicity, focus and peace of mind.