Retirement Step by Step
Life-cycle funds put your investment portfolio on autopilot, with bold strategies giving way to safer bets as you get older
The pros:
Using life-cycle funds may be better than investing entirely on your own, particularly if, like most investors, you don't have the money to seek out professional advice.
Target funds offer instant diversification for investors who don't have much money to invest at first.
Target funds are also ideal for young investors just getting started, says Everette Orr, president of Orr Financial Planning in McLean, Va. Novice investors typically aren't aware of the importance of diversifying between stocks and bonds--not to mention the need to own small-capitalization and large-cap stocks as well as domestic and foreign securities.
Life-cycle funds are delivering better results than do-it-yourselfers achieve. In 2003 and 2004, a Hewitt study shows, 401(k) investors who used target retirement funds, either as the sole investment option or in conjunction with other investments, outperformed workers who invested entirely on their own. In 2004, the target retirement fund investor's returns were 11.6 percent, while the do-it-yourselfer earned just 9.6 percent.
What's more, Hewitt projected that the workers using target retirement funds could expect to earn 8.5 percent a year on average in the long term, while do-it-yourselfers would make 7.4 percent annually.
One percentage point might sound like a pittance, but it adds up mightily over time. A 25-year-old who invests $5,000 a year and earns 7.4 percent on it annually would accumulate just under $1.2 million by the age of 65. That same 20-something, earning 8.5 percent a year, would accumulate a nest egg of more than $1.6 million.
"It's staggering, but by adding 1 percentage point more in annual returns, you might be able to fund more than 10 extra years of spending in retirement," says Thomas Fontaine, senior portfolio manager with the asset management firm AllianceBernstein.
Young investors tend to be too conservative, says Lori Lucas, Hewitt's director of retirement research. The average 20-something invests only around 59 percent of his money in stocks or stock funds (and a dangerous amount of that is in company stock). Most target retirement funds will start a young investor off with more than 80 percent in diversified equity funds.
A recent study by Vanguard, a major provider of target retirement funds, shows that investors who use life-cycle funds are on average 83 percent in equities in their 20s, 75 percent in their 30s, 61 percent in their 40s, and 51 percent in their 50s. Investors using old-fashioned asset allocation funds or investing on their own tend to keep 60 percent to 70 percent in stocks between their 20s and 50s.
Thinking of using a life-cycle fund? Here are some tips:
Not all target date funds are alike. For instance, while the MFS 2030 fund invests nearly 100 percent of its assets in stocks, the Schwab Target 2030 Fund keeps less than 80 percent of its holdings in equities (table). At age 65, some funds, such as those offered by Schwab and T. Rowe Price, still keep a majority of their assets in stocks, while Fidelity shifts to around 45 percent equities.
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