Life-Cycle Funds: Targets, Not Guarantees
I have a deep and abiding suspicion of easy answers. That's why the idea of life-cycle funds makes me uneasy.
Nonetheless, more and more retirement savings plans' participants are likely to be offered these funds by their employers. And for those who otherwise might have parked their retirement money in lower-return investments or too much company stock, they probably are an improvement.
But are they the best solution? For all their supposed benefits, there are at least a few serious concerns.
Life-cycle funds are aimed at a year in which you might retire or be close to retiring -- say, 2015 or 2030. They offer investors a mix of higher-return choices such as stocks and lower-risk products like bonds, and the mix moves from riskier to more conservative as the target date approaches. (They're also sometimes referred to as target-date funds or time-based funds.)
Because these funds have been around only since 1994, there aren't a lot of data on how well they balance risk versus return to deliver a fully funded retirement. But last year's Pension Protection Act made it likely that such funds will become a frequent default investment -- the investment into which a participant's money is automatically steered when the employee doesn't make another choice.
"It is not inconceivable that within a few years, life-cycle funds will represent a majority of the assets in the nation's 401(k) plans," according to a study last year by Turnstone Advisory Group, a company that provides independent advice and analysis of investment services to employers. Its study was one of the first attempts to compare life-cycle funds' performance.
The argument for making life-cycle funds a "safe harbor" for workers' savings was that the funds are likely to produce better returns than some previously available choices. Even analysts who raise concerns about the funds agree that they're an improvement over money-market funds or sometimes randomly chosen mutual funds.
My own misgivings are simple: Different funds have different formulas, and they can't all be right. For instance, a Consumer Reports analysis in 2006 found a wide variation in the level of stock investment in funds with a target date 2020, ranging from 50.1 percent of holdings to 86.3 percent.
Zvi Bodie, professor of management at Boston University, and Joe Nagengast of Turnstone raise another important concern -- the fact that the funds can't guarantee that investors' retirements will be fully funded. The problem, they say, is that consumers may assume that the target dates mean they will be. A variety of factors, however, determine whether a retirement is fully funded by any given date, including how much an investor puts aside and how well the market performs.
"If I, as a consumer, am told that I'm joining a retirement fund that is dated 2020, 13 years from now, what exactly is supposed to happen?" Bodie said. "The answer is nothing. The only thing the date is used for is to specify some changing mix of stocks, bonds and cash."
It's not that the fund companies are misleading investors, Bodie and Nagengast are quick to say, but that investors are likely to view the target-date funds as a surer thing than they are, which is investments in markets with all the risks that entails.
"If you put 2020 on the name of the fund, I don't care what you say after that; that's all people are going to focus on," Nagengast said. "If you talk to the mutual fund companies, they say: 'It's just a mutual fund. We're not liable for anything any more than with any other mutual fund. We're responsible for managing according to the mandate, but we can't guarantee results."
Nagengast also says fees are too high and should come down. "But I don't think that is a reason not to use them. Most providers need to lower their fees, but they're still a better choice for most people than doing it on their own."
Nagengast and his co-authors found in their 2006 study of funds that "most fund families of life-cycle funds are, in fact, producing near market-like returns for their longer horizon fund investors in up markets and protecting assets for their shorter-horizon fund investors in down markets." And that's still generally true, he said of the results of a much larger study completed this year in conjunction with PlanSponsor, an employer resource for pension and retirement issues.
But he and Bodie said there is a danger that the funds will be too heavily invested in stocks at or near the point at which investors begin withdrawing their money. If you start taking out money when the market is headed down, you could be out of money before it recovers.
Still, even with the caveats, life-cycle funds may be a better investment option for many individuals than trying to create the right mix of investments as they age. If that sounds good to you, go ahead. But remember, they're not a guarantee of a fully funded retirement.