“What’s your take on Life-cycle funds? The reality is I don’t have time to pick my funds and rebalance my portfolio as I get closer to retirement – nor do I want to. I’m looking at the Freedom 2040 fund, based on my age. It looks like a basket of funds that rebalance as I get closer to retirement. Management fees look minimal and I get professional management. The 1, 3 and 5 yr returns outpace the S & P 500. What’s not to like?”
So wrote Dallas reader D.G., as he contemplated his nest egg in the closing days of 2005.
What about these “life cycle” funds?
D.G. is not alone. After a slow start, life-cycle mutual funds appear to be taking off. The funds, which manage a portfolio toward a particular date, like retirement, are a real “Let George do it”—they make all the decisions for you. Fidelity Investments, for instance, recently announced that commitments to its Freedom funds in IRAs were up 80 percent in the last year. Many 401(k) plans now offer life-cycle funds pegged for workers at different ages.
But are they the solution to building a retirement nest egg?
I think the answer is “almost.”
The best thing that life-cycle funds do for investors is take them out of the mutual fund dartboard game. By making a decision for a single portfolio that contains a variety of manager selected funds in different asset classes, the investor gets proper asset diversification, and an age-related asset allocation. He also gets a ticket out of the nasty business of guessing the best fund choice for the next few months.
The problems of typical 401(k) investing
Life-cycle funds are the best tool yet for avoiding problems like rearview mirror investing (picking a fund that has done well in the last year) or fad investing (like technology funds in 1999). The consequence is fewer downdrafts, less risk, and better odds of a reasonable long term return. An examination of their performance, using the Morningstar database, shows the funds are going just that.
According to Morningstar there are some 668 life-cycle funds. That number, however, is inflated by the proliferation of marketing distribution channels such as no-load, A shares, B shares, etc. In fact, there are about 160 distinct funds and they, in turn, fall into three familiar Morningstar categories:
- “Conservative allocation” for older savers close to retirement who want a relatively low exposure to equities.
- “Moderate allocation” for mid-career savers who can take more risk.
- “Large blend” for young workers who can afford the risk of investing most of their savings in common stocks.
As we would expect, the large blend life-cycle funds did best over the last ten years, returning an average annualized 8.59 percent, while the conservative allocation funds provided the lowest return, an average annualized 6.66 percent.
In 2002, the worst year of the 2000-2002 stock market crash, the returns were reversed. The large blend life-cycle funds for younger workers lost an average of 17.53 percent while the conservative allocation funds lost an average of only 3.55 percent.
But what about costs?
So, as D.G. asks, “What’s not to like?”
Answer: Costs.
To build life-cycle funds, fund managements go through their collection of funds and build portfolios from retail mutual funds. It’s good for them because they’ve found another way to sell their funds.
It’s not so good for savers because it’s the same old, same old when it comes to fund expenses. Fidelity Freedom 2020 (ticker: FFFDX) is the largest of life-cycle fund, with $13 billion in assets and an annual expense ratio of 0.75 percent. The fund contains a total of 24 different funds— 17 Fidelity equity funds, 5 Fidelity fixed income funds, and 2 Fidelity short term fixed income funds. No fund accounts for more than 9 percent of assets.
By retail fund industry standards, that 75 basis point expense ratio is cheap. It’s well under the cost of the average equity or fixed income fund. It’s a good example of Fidelity as a tough competitor.
There is, however, a different standard. We need funds with institutional pricing if we are going to reach our long term retirement goals. As a benchmark, I offer the life-cycle funds available to federal employees.
They cost only 6 basis points a year, or .06 percent.
On the web:
Information on the Federal Thrift Savings Plan “L” funds: http://www.tsp.gov/lifecycle/flash/index.html
Photo: Scott Burns
(c) A. M. Universal, 2006