Tailoring Your Allocation to the Stage You're in With Life Cycle Funds

In an effort to make financial life easier, the concept of a "life cycle" mutual fund was born. The idea was to offer specific asset allocations and investment selections for specific investment objectives—all bundled up in one fund. And some companies provide these kinds of funds in their 401(k) plan offerings.

Today, life cycle mutual funds go by many names including "strategic allocation", "asset manager," "personal strategy," "life strategy" and "target retirement." However, the underlying theme of these funds is the same—one fund that would answer the asset allocation needs of an individual at a particular stage in life.

But nothing is ever easy. Although these funds were created to make things simpler for investors, the layered complexity of life cycle fund choices presents a difficult investment task.

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How do you sort through the options?

Grouping the life cycle funds by their asset allocation approach gives you a starting point. The three major categories are: active, fixed allocation, and transition.

Active Life Cycle Funds

The active life cycle funds have a few elements in common. All have fund offerings that are titled on the continuum from aggressive to conservative or growth to income and have at least three funds. These active life cycle funds invest in individual securities, whether stocks or fixed-income investments, rather than other mutual funds.

But the real story is why they are saddled with the term 'active'. If you read the prospectus of any of these funds (and you should before investing) you'll find that, although they give a long-term strategic target asset allocation, they designate wide ranges for certain asset categories. For example, they can invest 0% to 15% in money market investments.

Basically, the portfolio manager will actively vary the asset allocation mix based upon their forecast of how well the various asset classes will perform relative to each other over some undefined period of time.

In other words, these active life cycle funds provide asset allocation, security selection and market timing services.

This latter activity presents some problems, as the active allocation approach may make it difficult to pinpoint an appropriate life cycle fund choice.

There are two crucial decisions for investors in fund groups that have a continuum of growth-to-income and aggressive-to-conservative funds: First, you have to decide which fund to start out with; and second, you have to decide when to jump to another as you move through your cycle of life. All trade off risk and return, capital appreciation and income:


  • The higher risk growth/aggressive fund portfolios are for investors with longer horizons or more tolerance for risk, variation in return and fund value.


  • The lower risk income/conservative funds are for investors with shorter horizons or less tolerance for risk.

    As your risk attitude changes, so should your life cycle fund choice. But it is not quite so easy to take your risk temperature. Wealth, health, family, employment and retirement plans can all affect your risk temperature. Quiz yourself annually on what's most important—capital preservation, income, wealth accumulation. It won't happen overnight, but you will know when to move down the risk ladder. Trust your financial instincts.

    Fixed-Allocation Life Cycle Funds

    The next category of life cycle fund is the fixed-allocation fund of funds group.

    These funds invest in a variety of other mutual funds, typically index funds, to cover all of the major asset categories.

    With fund-of-funds formats, there is always a question of fund expense. Typically, but not always, the life cycle fund has its own fee, which is layered on top of the expenses of underlying funds.

    Transition Life Cycle Funds

    The final group of life cycle funds are the transition funds.

    Here is how they work: Each fund family that offers transition funds has a series of target maturity funds ranging from up to fifty years out, typically in five-year increments, and each fund becomes increasingly conservative—lower risk, more income, less equity, more fixed income, more domestic stock, less international—as the target maturity date approaches.

    For example, five to 10 years after the target retirement date, the fund will have fully transitioned into an income fund.

    While the asset allocations of the transition life cycle funds tend to be similar, the individual investment approach for the funds can be quite different.

    • Some invest in only a limited number of index funds;
    • Some invest in a large number of actively managed funds.

    Most likely, the actively managed funds will trade more than those using index funds and will incur more transaction costs, brokerage fees and a spread between the bid and the asked of security prices that reduce total returns.

    The Good Life

    Which life cycle fund approach is best for you?

    • If you are comfortable with asset allocations that may vary, you have confidence that changing allocations in response to anticipated market trends will improve performance and you prefer to pick a fund profile (aggressive, moderate, or conservative) and change funds when you slip into another profile (but don't forget tax implications), then an active life cycle fund may be your best choice.
    • If you want a relatively constant allocation but you prefer to select and change from one fund profile to another when your personal circumstances change, then a fixed-allocation life cycle fund may be your best choice.
    • If you do not want to select a fund profile, you are comfortable with selecting an estimated retirement date and your final, in retirement, portfolio objective is income, then the target date, transition life cycle funds may be your best choice.

    Once you select the life cycle approach with which you are most comfortable, including the choice of active management versus index fund, then the next decision you must make is the individual fund or fund family choice.

    Needless to say, you certainly should look at each fund's performance. But you should also keep an eye on the risk. Compare conservative funds to conservative funds, aggressive to aggressive, income funds to income funds, and similar target maturities to each other.

    What else should you look for?

    Expenses are reflected in past returns, but going forward, returns are not predictable while expenses are certain. So, if you can't make up your mind over two similar funds, opt for the one with lower expenses. Note that expense ratios do not reflect the expense ratios of the underlying funds for fund-of-funds investments.