The concept is so simple: pick a fund, put all of your money into it and forget about it until your reach retirement age. "Life-cycle funds," also referred to as "age-based funds" or "target-date funds," have an intrinsic appeal that's hard to beat, and fund companies are capitalizing on the concept by rolling out new funds as fast as they can. Of course, nothing is ever as simple as it seems.
Two Types of Life-Cycle Funds
There are two types of life-cycle funds from which you can choose: target date and target risk.
A target-date fund operates under an asset allocation formula that assumes you will retire in a certain year, and adjusts its asset allocation model as it gets closer to that year. The target year is identified in the name of the fund. So, for instance, if you plan to retire in or near 2050, you would pick a fund with 2050 in its name.
With target-risk funds, you generally have three groups from which to choose. Each group is based on your risk tolerance, whether you are a conservative, aggressive or moderate risk-taker. If you decide later that your risk tolerance has or needs to change as you get closer to retirement, you have the option of switching to a different risk-level.
A Comparison of Funds
The first challenge with target-date funds is that all funds are not created equal. A 2012 sample of approximate holdings demonstrates this point.
|Fund||Equity Proportion||Fixed Income Proportion||Equity Allocation||Fixed Income Allocation|
|Fidelity ClearPath® 2045||84.1%||15.9%||15.27% Canadian Equity||8.7% Investment Grade Bonds|
|15.0% U.S. Equity||7.2% High Yield Bonds|
|15.0% International Equity|
|T. Rowe Price Retirement 2045 Fund||89.1%||10.9%||62.1% Domestic Stock||5.3% Domestic Stock|
|26.6% Foreign Stock||3.0% Cash|
|0.4% Preferreds||2.1 % Foreign Bonds|
|Vanguard Target Retirement 2045||90%||10%||63.1% Total Stock Market Index||10.0% Total Bond Market II Index|
|26.9% Total International Stock Index|
While each of these funds claims to be a good choice for investors seeking to retire in 2045, the contents of the funds are dramatically different. The least of these differences is the proportion of funds allocated to fixed-income securities, which varies by more than 5%. Keep in mind that this proportion may vary even more over time. That variance can be of particular concern to retirees. One retiree may have enough money on hand to invest strictly in bonds and other fixed-income securities. Another, requiring both growth and income, may need an equity component to keep the portfolio on track. A fund that meets the needs of one of these investors is unlikely to meet the needs of the other.
Beyond holdings, the funds also differ in terms of investment style. For instance, depending on what you're looking for, you can find a fund that is is made up entirely of index funds. Therefore, investors that prefer active management would need to shop elsewhere.
Funds also differ in terms of expenses. While each is a fund of funds, with all funds creating a portfolio that consists of multiple underlying mutual funds, each of those underlying funds has an expense ratio. Depending on how the fund family calculates fees, those expenses can add up quickly. For instance, one fund company may charge 0.21% of assets under management, while another may charge twice or even three times that amount. As such, expenses must be a point of consideration when choosing these funds.
Beyond expenses, another consideration is that each of the underlying funds in a target portfolio is offered by the same fund company. Every target fund in Vanguard's lineup has nothing but other Vanguard funds inside the portfolio. The same goes for the Fidelity and T. Rowe funds. In an era with more than a few corporate scandals on record, you are trusting all of your assets to a single fund family.
Choosing a fund is one thing, but correctly implementing the strategy is another thing altogether. Target retirement funds are designed to be the only investment vehicles that an investor uses to save for retirement. Investors that have their assets in a target retirement fund skew their asset allocation if they also put money into other investments. So, for example, if a target fund has an 80% stock and a 20% bond asset allocation, but the investor purchases a certificate of deposit with 10% of his or her retirement assets, this effectively decreases the stock allocation of the investor's overall portfolio and increases the bond allocation.
Even investors that use the funds correctly as their sole retirement investment vehicles need to pay attention to the overall asset allocation, as the asset allocation of investments in a target-date retirement fund changes as the target date nears. If retirement is fast approaching but the balance in the investor's account isn't enough to meet his or her retirement needs, a fund that moves to a more conservative asset allocation may have no hope of providing the type of investment returns that will be required to keep those retirement plans on track.
Similar concerns come into play once retirement age is reached. While many investors view these funds as being designed to provide for retirement on or around a certain date, assets can be left in the fund after retirement. Here again, the size of the nest egg may indicate that a conservative strategy isn't enough to keep the bills paid and the lights on.
Last, but not least, reaching retirement by the chosen date is not just a function of choosing a fund and putting all of your money into it, it's also about putting the right amount of money into that fund. Regardless of the chosen date, an under-funded nest egg will simply not support a financially secure retirement.
Do Target-Date Funds Have a Place in Your Portfolio?
Anytime you are putting your money into somebody else's hands, beware. Just because the fund says "2045" on the label, this doesn't mean that a raging bull market will start and end just in time to keep the fund at the top of its game, nor does it mean that a severe bear market won't hit in 2044 and decimate the fund's holdings. In the end, the responsibility for retirement planning rests with the investor.
Fortunately, target retirement funds offer something for just about everyone. Active management, passive management, exposure to a variety of markets and a selection of asset allocation options are all available. Investors that are comfortable designating a percentage of their retirement and then forgetting about it for 30 years may be completely comfortable with target retirement funds, just as investors that don't mind doing a little research might find the exact fund they are looking for in the target fund lineup.