A tricky balancing act

Life-cycle mutual funds automatically shift assets as retirement nears, but need to be monitored


Life-cycle funds are gaining traction with investors who want to simplify, but this booming mutual fund category still requires a sharp consumer's eye.

Assets in mutual funds that automatically rebalance toward a specific target retirement date grew nearly 70 percent in 2005 over the previous year, to $70 billion, according to the Investment Company Institute, which tracks industry flows. Of that, $48 billion was in employer retirement plans.

In addition to industry leaders Barclays Global Investors, T. Rowe Price Investment Services Inc., Fidelity Investments and Vanguard Group Inc., among others, the AARP has launched its own target retirement funds. And the federal government is about to complete its first full year of offering its own target-date funds in the federal Thrift Savings Plan, the retirement fund for federal workers.

As of the end of June, about 1 in 10 federal workers -- or more than 329,000 people -- in the thrift plan were investing in one of five portfolios that automatically shift assets into less risky categories as a participant gets closer to retirement, according to government data.

"I believe life-cycle funds have been the greatest thing to hit defined-contribution plans yet," said Gary Amelio, executive director of the Federal Retirement Thrift Investment Board, which oversees the government savings plan.

Proponents of these one-stop shops, like Amelio, say the funds will be a boon to retirement savers who notoriously ignore the asset allocation in their workplace and individual retirement accounts. By continually rebalancing and adjusting the portfolio as an investor ages, they say, potentially dangerous emotional investment decisions are taken out of the equation.

Investors, however, still need to scrutinize the underlying investments within target-date funds to be sure the allocation makes sense for them. Funds with the same target date can have very different allocations of stocks, bonds and cash.

It's important for investors to match their fund's allocation with their own risk tolerance, and to keep track, because funds can change the allocation to make them more aggressive, not less, even as the target date moves closer.

One person planning to retire in 2040 may have a much lower risk tolerance than others in that same age group, for example. Or another investor may have outside investments that will need to be reconciled with the target-date fund's mission.

Because the entire category of life-cycle funds is only about a decade old, it's too soon to know for certain how its investors have fared, said Mark Labovitz, a Lipper Inc. research analyst in Denver.

So Labovitz created a study using 40 years of stock-return data to back-test life-cycle funds from four big providers: AllianceBernstein Investments Inc., Fidelity, Vanguard and T. Rowe Price.

The test showed AllianceBernstein's portfolios beat out its competitors, both in raw and risk-adjusted returns.

Why? Because every provider's funds use different levels of stock and bond market asset classes at investors' different ages.

AllianceBernstein's funds included an aggressive amount of equities, real estate investment trusts and several -- but not too many -- different asset classes for diversification, Labovitz concluded.

Last spring, Vanguard and Fidelity both changed the asset allocation in their target-date funds to include more stocks.

Fund costs are another big point of differentiation.

By lifting one finger -- instead of the zero required in life-cycle funds -- an investor can get a broad mix of stocks and bonds and pay only a few basis points in costs using index funds or exchange-traded funds. But that requires at least some minimal attention and rebalancing over the years. With a life-cycle fund, said Morningstar Inc. analyst Greg Carlson, you can have it done for you.

But not all funds charge the same. While some funds in the category charge expense ratios of nearly 1.5 percent -- compared with an industry average of just over 0.9 percent -- plenty can be had for 1 percent or less, and fees in general are dropping, Carlson said.

"I would avoid funds charging more than 1 percent in this category," he said.

While even that fee may sound expensive -- especially if the underlying investments are super-low-cost index funds -- it represents a relatively cheap way to get exposure to a lot of asset classes, Carlson said.

"Investors in target funds tend to stay the course," said Tim Kohn, defined-contribution specialist with Barclays Global Investors.

Kohn said hye believed the category was still in its infancy, despite the huge growth in recent years. He said the company believes half to two-thirds of the $3 trillion 401(k) plan market would be best served in life-cycle funds.

"Fees can be compressed much further, as more players come into the market and as we move from active management to a low-cost index solution," he said.

Finally, Carlson said, investors considering target-date funds need to look at investment subcategories in addition to the overall stocks, bonds and cash mix.

In a report this year on the category, Carlson noted that several life-cycle funds carry a significantly smaller portion of assets in foreign investments than are typically recommended by financial advisers for diversification.

After studying the category, Carlson gave top marks to life-cycle funds from low-cost leaders Vanguard and T. Rowe Price, for their quality of underlying funds at still reasonable prices.

Investors with more than one retirement account have additional considerations.

The value proposition becomes more complex, experts said. If your company 401(k) includes a solid life-cycle fund option, use your outside accounts to fill in any gaps in asset classes, perhaps foreign equities or subclasses such as micro- and small-capitalization stocks, they said.

Janet Kidd Stewart writes for Tribune Media Services.

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