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
If the 1990s was the era of the do-it-yourself investor, then this decade may well be remembered for a new breed: the set-it-and-forget-it type. Dangle a 401(k) or similar retirement plan in front of most Americans, and they'll jump right in. They know they need to save and invest for the future.
Yet there's a troubling trend: Once the typical investor sets up his plan, he might as well be comatose. From the bear market of 2000 to a new bull market in 2004, more than 3 in 5 investors in 401(k)'s failed to make a single change to their accounts, according to a recent survey by consultants Hewitt Associates.
True, investors didn't panic and sell when stocks were at their lowest, but financial planners say their lack of engagement is downright frightening.
Enter the mutual fund industry's solution to the problem: the life-cycle fund. Also known as a target retirement portfolio, the life-cycle fund is a new twist on an old investment standby: the asset allocation fund. But unlike those all-in-one mutual funds, which give you a diversified but unchanging mix of stocks, bonds, and cash, life-cycle funds automatically evolve as you age.
When you're 25, these portfolios might put 80 percent or more of your money in stocks. But as you turn 40 and then 50 and eventually retire, the funds will gradually and automatically dial down the risk in your portfolio by buying more bonds.
Life-cycle funds put your portfolio on autopilot for a lifetime: Set it and forget it.
"People are after simplicity now," says Jeff Mortimer, head of equity portfolio management at Charles Schwab Investment Management, which recently launched its own target retirement funds. "They learned over the past five years or so that investing isn't as easy as they thought."
Target retirement funds aren't new--Fidelity's Freedom Funds were launched in 1996--but they've "really only begun to come into their own in the last 12 months," says Andrew Clark of mutual fund tracker Lipper Inc. Last year, investors plowed nearly $23 billion into target retirement funds, according to the financial research firm Strategic Insight, more than 12 times the amount they stuffed into these portfolios in 2000.
If life-cycle funds seem familiar to you, they should: Baby boomer parents saving for their kids' education in popular 529 college savings plans have age-based investment options using the same concept.
With more and more fund companies bringing out new life-cycle options--Schwab, MFS, and Putnam are among the latest to have joined this crowd, competing with longtime participants like Fidelity, Vanguard, and T. Rowe Price--assets in such portfolios are likely to grow by leaps and bounds.
So, are life-cycle funds for you? Financial planners have mixed opinions.
The cons:
Many target date funds tend to be too conservative, especially at retirement, when today's 60-something might expect to live for another 20 to 25 years.
A cookie-cutter approach to retirement planning can be dangerous. The only factor these funds use to make investment decisions on your behalf, says Gayle Oboy, a financial planner in Marion, Ohio, is the date at which you plan to retire. Yet two people who are roughly the same age and who plan to retire at around the same time might have different financial needs and far different tolerances of investment risk.
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.
So make sure you're comfortable with the asset allocation strategy of the fund you pick.
Don't pick a fund solely based on your projected retirement date. Target retirement funds give you a choice based on dates. If you're 15 years away from retiring, you might choose a 2020 fund. If you're 35 years off, you might decide on a 2040 fund.
These dates are usually a hypothetical retirement at age 65. But you may choose to work longer, which means you might be better off in a fund that's dated to when you turn 70, not 65.
And even if you do expect to retire at 65, you may not need to tap the bulk of your assets until much later. If you have a traditional pension from your employer, that plus Social Security might cover basic expenses until you're 70 or older.
Don't feel obligated to stick with any single target date fund for your entire life. If you're 40 and begin investing in a 2030 fund that's too conservative for you, there are no rules preventing you from shifting to a more aggressive 2035 or 2040 fund later on. Or try out a target fund when you're young, and when you're more experienced as an investor and have more money saved, leave the fund and seek out individualized professional advice.
Don't be afraid to put most of your money into a target fund. Life-cycle funds invest in a collection of other mutual funds and are broadly diversified. The Fidelity Freedom funds, for example, were "designed as a single-fund solution," says John Sweeney, senior vice president with Fidelity Personal Investments.
Don't tinker too much. Keep your core holdings in a life-cycle fund because it will cover the basic asset classes. Then, you may want to put a small portion of your money in alternative investments. Many target date funds don't have much stake, for instance, in real-estate investment trusts, gold, or commodities.
Always keep fees in mind. Most life-cycle funds are mutual funds that invest in underlying mutual funds--funds of funds, in other words. So, two layers of investment management fees apply. Consider sticking with a life-cycle fund that charges less than 1.5 percent in total annual expenses. Some come much cheaper. Vanguard's offerings, for instance, have a total expense ratio of just 0.21 percent to 0.22 percent.
Life-cycle funds are an appealing solution that can make anyone a set-it-and-forget-it investor who gets reasonable returns. But they aren't a magic bullet. You still have to save in a disciplined way to reach your retirement goals. And for that, you're on your own.
This story appears in the February 13, 2006 print edition of U.S. News & World Report.