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The Correct Way to Use Lifecycle Mutual
Funds
Target-date and target-risk funds have become popular
investments among 401(k) plan participants and retirement
investors, especially those who have neither the time, knowledge
nor inclination to create and manage an investment portfolio.
For instance, recent research by Financial Research
Corporation, shows that assets in target-date retirement funds
has risen dramatically over the past several years, rising from
$14.5 billion in 2002 to $86.7 billion in May, 2006. And assets
in lifecycle funds have risen from $54.6 billion in 2002 to
$145.9 billion in May, 2006. What's more, FRC is predicting that
both target-risk and target-date retirement funds, sometimes
referred to as lifecycle or lifestyle funds, will continue to
grow dramatically over the next four years, with target-date
retirement funds hitting some $30 billion by 2010. Target-date
funds are mutual funds that base their asset allocation
around a specific date, and then rebalance to more conservative
allocations as that date approaches, according to FRC. Target-risk
funds are mutual funds that build their asset allocations
around a pre-specified level of risk, and then rebalance to
maintain that risk level.
The appeal of such funds, which are designed as a complete
solution for investors with similar risk profiles or time
horizons, is perhaps obvious. Such funds provide instant
diversification and the benefits of disciplined portfolio
rebalancing. Technically, a fund of funds, target-date and
target-risk funds invest in a variety of mutual funds, typically
those offered by the same fund family. For instance, the average
2010 target-date fund invests in 15 funds, according to a recent
Brigham Young University study and has 35.5 percent of its
assets in U.S. stocks, 8.5 percent in non-U.S. stocks, 45.2
percent in bonds, 10 percent in cash, and 0.8 percent in other
types of securities. In addition, the manager of such funds will
rebalance the portfolio adjusting the mix of the portfolio to
become more conservative as the portfolio nears the
target-retirement date.
And most important, such funds are easy to use since
investors and financial planners for that matter don't have to
search through thousands of mutual funds to create a portfolio.
A recent study suggests that three in four financial planners
are now recommending target-date and target-risk funds for
investors with less than $100,000 to invest.
But recent studies also indicate that both target-date
retirement funds, and lifecycle funds, are being misused.
Indeed, studies suggest that 401(k) plan participants are mixing
such funds with other funds and using them as conservative
choices along with several other selections. This, say financial
planners, abrogates the purpose of the funds.
For instance, according to Hewitt Associates in June 2006,
the average 401(k) plan participant had 6.4 percent of their
assets in a target-date or target-risk fund, 21.7 percent in a
stable value fund, 22.2 percent in company stock and 20.7
percent in U.S. large-capitalization stocks. According to
financial planners, the mix should be almost reversed with the
greater percentage in the target-date or target-risk funds and
the smaller percentage allocated to investments that don't
duplicate the funds or investment objectives in the target-date
or target risk funds.
To be fair, a recent Hewitt Associates study did show that
more and more 401(k) plan participants seem to be using
lifestyle and lifecycle funds correctly, investing their entire
plan balance into the funds. Hewitt noted in a May 2006 study
that the overall number of employees investing in lifestyle and
lifecycle funds has remained constant, but the number of
employees using them as turnkey solutions increased. For
instance, one in five employees holding a lifestyle or lifecycle
fund had their entire 401(k) balance in them in 2005, up from 15
percent in 2004. In addition, nearly half of employees with less
than one year of tenure investing in a lifestyle or lifecycle
fund invested all of their 401(k) monies in a single lifestyle
or lifecycle fund in 2005, an increase from 34 percent in 2004.
So what then is the right way to invest in target-date or
target-risk funds? Investors need to get a sense of the time
horizon, tolerance for risk and investment goals. In the
parlance of professionals, investors need to construct an
investment policy statement which outlines, among other things,
a target asset allocation or mix between stocks, bonds and cash.
Most lifecycle funds are designed to take away all that work,
but not all lifecycle funds are created alike, so it's important
that investor find the lifecycle fund that best matches their
personal tolerance for risk.
With that an investor can then examine whether it's better to
invest in many different types of funds using the help of a
professional or to use a target-date or target-risk fund that best
matches their personal goals, time horizon, and tolerance for
risk. That's especially important since target-date and
target-risk funds may all sound the same in theory, but are
quite different in reality. For instance, the asset allocation
of such funds will quite often differ quite dramatically from
one fund firm to another. What's more, the rate at which a
target-date retirement fund becomes more conservative over time
will differ dramatically. And while these funds often have
similar sounding names, the performance and fee associated with
these funds will vary greatly too.
August 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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