The Rise of Lifecycle Funds Targeting Employees Risk Tolerance And Age

By Steve Tuckey

Many money managers are promoting “lifecycle” and “lifestyle” funds that are supposed to ease the burden of investing assets by creating professionally managed portfolios designed for and targeted at investors in specific age groups and risk-preference groups

Is adding a lifecycle fund family to plan investment menus a great way to improve employees results, or is it just another way to make the menus longer?

Most investment experts interviewed agree that lifecycle funds can be great tools for helping employees diversify, but they warn that the funds are no substitute for personalized counsel from a knowledgeable advisor.

“There is more to planning for retirement than picking the year you wish to hit the beach,” says Kerry OBoyle, an analyst at Morningstar.com, an arm of Morningstar Inc., Chicago. “Unlike a financial advisor, [a lifestyle fund] wont tell you if your goal is realistic or if you are saving enough to reach that goal.”

Lifecycle funds fall under 2 main headings: “target-date funds” and “target-risk funds.”

Target-date funds, which usually are named for the year the typical holder intends to retire, are seen as the funds that put the most responsibility in the hands of the managers. The funds in this group require the least investor involvement in that the portfolios are rebalanced at certain specified intervals to match a clients risk tolerance, which is assumed to lessen as the decades go by. Such rebalancing can take place automatically or at the clients initiative at the specified time periods.

Target-risk funds build their allocation around a pre-specified level of risk, and then undergo rebalancing so as to maintain that risk level.

In addition to being convenient to use, many lifecycle funds also are cost-effective. Investment companies such as T. Rowe Price, Baltimore, dont charge anything for putting portfolios together; investors merely pay the expenses of the underlying funds.

Although Fidelity Investments, Boston, says it introduced the first lifecycle fund in 1988, the concept did not really catch on until the late 1990s.

While the concept remains somewhat controversial, lifecycle funds certainly are proliferating.

Between December 2001 and September 2004, target-date and target-risk funds have achieved annual growth rates of 51% and 20%, respectively, compared to an 8% annual growth rate for all long-term assets, according to Ross Frankenfield, an analyst at Financial Research Corp., Boston.

Within the target-date category, Fidelitys Freedom Fund remains the dominant player with 73% of the category assets through September 2004.

Although Fidelity held the lions share of the target-date fund assets, it accounted for only 39% of the third-quarter 2004 net sales, and that demonstrates the increased competitiveness within the target-date fund category, Frankenfield says.

The target-risk category also is becoming more popular. Like the target-date funds, target-risk funds reported $3 billion in third-quarter 2004 net inflow.

Terrence Herr, with Herr Capital Management L.L.C., Chicago, says he recommends the target-date lifecycle funds for clients with retirement plan accounts with less than $100,000 in assets.

“Those are people with 401(k)s who are never going to talk to an advisor,” Herr says. Investing in a target-date fund “makes sense because it automatically diversifies them.”

Herr encourages any client with more than $100,000 to invest in the more hands-on target-risk funds, even if the client prefers not to tinker too much with portfolio management.

Plan members may be happier with the results they get if they base allocation decisions on risk tolerance levels rather than age, Herr says.

But Mark Ferris, an Old Saybrook, Conn., advisor, is an enthusiastic booster of the lifecycle concept even for clients with larger portfolios.

“Why not?” he asks. “A good asset is not bound by the number of zeros after the one.”

Many advisors offer caveats about the proper use of lifestyle and lifecycle funds.

Lifestyle funds can vary widely in terms of the aggressiveness of their asset allocations and the types of funds in which they invest. “Investors need to carefully choose their own risk tolerance in choosing such offerings,” says OBoyle, the Morningstar analyst.

Even if the level of risk tolerance is right for a plan member, “the challenge of lifestyle funds is that they dont always have the mix of assets you want,” Herr says. “For example, real estate would have been a great place to have some exposure, but most lifestyle funds would not have it.”

Gary Williams, a Columbia, Md., planner, sees lifecycle funds as valuable for retirement plan members with less than $25,000 in retirement plan assets and those allocating 529 college education plan funds. But he contends that even investing in “turnkey portfolios” requires advisor input.

“For example,” Williams says, “with outside factors such as a rising interest rate environment, you would want to ease out of bond funds, even if you are supposedly at that less risk-averse stage when bonds are appropriate.”

Rick Tidball, a Pittsburgh planner, refuses to invest his clients assets in lifecycle funds.

He rejects the argument that the funds are more economical, and he says he would prefer to do the risk tolerance analysis for his clients rather than have the risk analysis handled through the use of a mass-marketed product.

“And then there is the fact that these are relatively new concepts, so there is really no long-term track record,” he says.

How effective are lifecycle funds where it really counts? In other words, portfolio diversification and investment results.

Because there is no long-term track record, the jury is out, but some early studies suggest that the funds could be meeting their goals.

A recent study conducted by researchers at Hewitt Associates Inc., Lincolnshire, Ill., looked at investment results for 1.7 million retirement plan participants.

Although 1 in 3 participants used lifestyle plans, only a small percentage used them for their original purpose: Only 13% of the lifestyle plan participants had all of their non-company stock in a single lifestyle fund.

“Most defined contribution plan participants mix and match funds with other funds as opposed to using lifestyle funds as turnkey investment solutions,” Hewitt researchers state in the study report. “The end result tends to be fairly homogenous portfolios, on average, across age groups.”

Nevertheless, those investors who used lifestyle funds, even partially, remained better diversified overall, the Hewitt researchers conclude.

Researchers at Manulife USA, Boston, conducted another study of 90,506 plan participants in 401(k)s.

The participants in the Manulife study were divided into lifestyle and non-lifestyle fund investors based on the investment risk inherent in the strategies they selected.

Within each risk category, lifestyle participants experienced between 2.4 and 3.9 percentage points greater annualized returns than non-lifestyle participants over the period from 1999 to 2003, according to the Manulife researchers.


Reproduced from National Underwriter Edition, January 6, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.