• Portfolio Strategies
  • Choosing the Right Mix: Lessons From Life Cycle Funds

    by William Reichenstein and William W. Jennings

    Choosing The Right Mix: Lessons From Life Cycle Funds Splash image

    Life cycle funds are a relatively new but growing phenomenon in the U.S. Each life cycle fund represents a diversified fund of mutual funds that a mutual fund family recommends for typical individuals who anticipate retiring on a specific target retirement date.

    For example, the T. Rowe Price 2020 Retirement Fund is a fund of funds that contains several stock funds and bond funds. It is designed as an all-in-one portfolio for typical individuals retiring in 2020. As the retirement date approaches, the portfolio becomes more conservative. In addition, T. Rowe Price provides life cycle funds for individuals retiring in 2045, in 2040, and so on through a portfolio for those who retired in 2005, plus a separate “income” fund for individuals who retired in 2000 or earlier.

    This article analyzes life cycle funds at four major mutual fund families to extract the consensus professional thinking about prudent asset allocations through a typical individual’s life cycle. The fund families are AllianceBernstein, Fidelity, T. Rowe Price, and Vanguard.

    In this article, we list investment advice that is embedded in the life cycle funds at these families.

    In addition, we discuss differences among the fund families’ current thinking. We also discuss their evolution in thinking.

    We believe individual investors can benefit from studying the asset-allocation thinking at these respected mutual fund families.

    Why They Were Created

    Jack is 32 years old with minimal understanding of investment issues. As a new employee, he signs up for his firm’s 401(k) plan. Feeling overwhelmed by the plan’s 60 investment choices, he opts for the default option, which, until recently, was a money market fund. This would have made a lousy retirement portfolio given Jack’s long investment horizon. To make matters worse, Jack, like many people, will go decades without rebalancing his retirement portfolio or changing the allocation of new contributions. Life cycle funds were created, in part, to help people like Jack.

    Fortunately for Jack, his new firm recently changed its default option to the age-appropriate life cycle fund. So, his contributions are placed in the life cycle fund for individuals retiring around 2040. This fund rebalances frequently to maintain a stable asset allocation, while slowly decreasing the target stock allocation as he approaches retirement. This allocation pattern makes more sense than an investment in a money market fund, although there are limitations to the effectiveness of life cycle funds (see box on page 6).

    Asset Allocations Among Funds

    Table 1 summarizes the allocation of life cycle funds at the four mutual fund families across the following asset classes:


    • U.S. stocks,
    • international stocks,
    • U.S. high-yield bonds,
    • U.S. high-grade bonds, and
    • cash plus short-term bonds.

    In addition, AllianceBernstein includes real estate investment trusts (REITs) as a separate asset class. High-yield bonds are also called low-grade, speculative, or junk bonds. High-grade bonds denote investment-grade or better bonds of intermediate-term or longer maturities. These portfolios represent the current recommendations of the four fund families for the allocation of a typical individual’s entire portfolio by age.

    Before proceeding to more important issues, it is useful to discuss the treatment of REITs. Are REITs stocks, bonds, or other?

    Perhaps because they are traded on stock exchanges, many investors consider REITs to be stocks. But in recent years, some scholars have lumped REITs with bonds; like bonds, REITs are generally held for their high yields. However, other scholars agree with AllianceBernstein and consider REITs to be a separate asset class (e.g., Burton Malkiel, “A Random Walk Down Wall Street,” 2003 edition, W.W. Norton & Company).



    Given the low correlation between REIT returns and, respectively, stock and bond returns, it is understandable that some professionals consider them a separate asset class. This article does not address the issue of whether REITs should be considered stocks, bonds, or a third asset class. T. Rowe Price and Vanguard hold REITs in their stock funds, while Fidelity holds REITs in stock and bond funds.

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    Given that REITs have a 2.5% weight in the Dow Jones Wilshire 5000 index, it seems safe to say that AllianceBernstein’s 10% REIT allocation for each of its life cycle funds represents a larger allocation than in the other families’ funds. To accommodate more traditional practices, when calculating their bond/stock asset allocations AllianceBernstein considers REITs to be half bonds and half stocks.

       The Limitations of Life Cycle Funds
    While life cycle funds may have their appeal, there are limitations to their effectiveness.

    First, each life cycle fund is designed to provide a one-stop portfolio for an individual’s entire financial portfolio for retirement. (The individual may keep a cash reserve in a bank savings account or money market fund to meet unexpected expenditures, but the assumption is his other assets are in the life cycle fund.) Suppose someone has assets in both retirement accounts and non-retirement accounts and wants to follow the asset location advice presented in “Withdrawal Strategies to Make Your Nest Egg Last Longer” [by William Reichenstein, November 2006 AAII Journal; available at AAII.com]. He may look at a life cycle fund to determine the overall portfolio’s target asset allocation. But, to the degree possible while attaining his target asset allocation, he should locate bonds in retirement accounts and stocks in taxable accounts.

    Second, a life cycle fund is not just another investment option in the retirement plan. Someone who invests equal amounts in, say, a life cycle fund, two bond funds, and three stock funds has misused the life cycle fund. Instead, the life cycle fund is designed to be a complete all-in-one investment.

    Third, life cycle funds are designed for “typical” individuals by age. The box on page 10 discusses factors that may help you assess whether you are a “typical” investor for someone your age.

    Common Advice

    There are several strands of advice that are embedded in all four families’ recommendations.


    First, they recommend that individuals follow a fixed-weight strategy with periodic rebalancing. For example, Vanguard recommends that individuals with a 2020 retirement date invest 60% in U.S. stocks, 15% in international stocks, 20% in high-grade bonds, and 5% in short-term bonds. Five years hence, its 2025 Fund will have the same target asset allocation. Although the target asset allocation slowly changes through time, at any point in time the actual asset allocation is not allowed to deviate materially from the target allocation.

    T. Rowe Price also follows an approximately fixed-weight strategy, but it allows its target asset allocation to vary based on perceived market prospects. That is, they practice tactical asset allocation. For example, T. Rowe Price may normally set the target U.S. stock allocation at 53% for its fund for individuals five years from retirement. Today, it may set the target allocation at 48% to 58% based on perceived market prospects. In contrast, if Vanguard set its normal U.S. stock allocation at 53% for its corresponding fund, then it would not allow that target allocation to vary based on market prospects.

    As a corollary, none of the families recommends market timing, where we define market timing as sharp variations in asset weights based on near-term expected returns.

    For example, someone following market timing may vary the U.S. stock allocation from 0% to 80% based on return forecasts for the next few months. In contrast, we call tactical asset allocation a strategy of allowing modest variations in asset weights—e.g., +/–5%—based on longer-term forecasts. In this framework, market timing represents large bets with potentially large losses, while tactical asset allocation represents small deviations from the fixed-weight strategy advocated by the fund families. Thus all four families recommend an approximately fixed-weight strategy.

    Three Broad Asset Classes

    Second, in general, the families recommend that the portfolios contain three broad asset classes: U.S. stocks, international stocks, and U.S. bonds. Fidelity, T. Rowe Price, and Vanguard recommend portfolios that contain only these broad asset classes. AllianceBernstein includes REITs as a fourth broad asset class.

    Despite this relatively minor difference, there is a consensus among the fund families that portfolios should contain primarily or entirely the three broad asset classes of U.S. stocks, international stocks, and U.S. bonds.

    As a corollary, none of the families recommends an allocation to international bonds, commodities, hedge funds, or structured products like index-linked bonds. The families apparently agree that alternative assets and exotic products are not a key to investment success.

    Well-Diversified Stock Portfolio

    Third, the families agree that the U.S. stock portfolio should be well diversified, containing small-cap through large-cap stocks and both value and growth stocks.

    All stock investors were hurt by the 2000–2002 stock market crash. But the investors hurt the worst were those who failed to diversify the U.S. stock portion of their portfolios. For 2000–2002, the Russell 1000 Growth index lost 55.6%, while the Russell 1000 Value index lost 14.6%. Similarly, the Russell 1000 index of larger stocks lost 36.7%, while the Russell 2000 index of small stocks lost 21.0%. Recent history provides an excellent example of why it is important to diversify the U.S. stock portion of the portfolio across styles—i.e., value and growth—and sizes—i.e., small-cap through large-cap.

    Decreasing Stocks With Age

    Fourth, all families agree that, as an investor ages, his or her stock allocation should decrease. Table 2 presents the recommended stock allocations across the four fund families. The consensus opinion is that younger investors with retirement dates of 2030 or later should allocate about 90% of their financial assets to stocks. Stated differently, individuals from their 20s through about 40 should have about a 90% stock allocation. Beyond age 40, their stock allocation should decrease.

    Typical new retirees, which we define as those who retired in 2005, should have stock allocations of 50% to 60%. Later in this article, we present a more detailed discussion of funds for retirees.



    The Stock Portfolios

    In addition to the earlier discussion, there are other interesting observations about the stock portions of the funds. First, the normal asset allocations for these families’ life cycle funds are size-neutral and style-neutral. Based on perceived return prospects, T. Rowe Price may insert a slight size or style tilt, but its normal asset allocation is size and style neutral.

    Not long ago, it was common to read recommendations that suggested that portfolios for the young should be tilted toward small-cap, growth, and international stocks, while portfolios for the old should have a tilt toward domestic large-cap and value stocks. Today none of these families recommends such age-based strategies. Perhaps the huge return differences among sizes and styles in the past decade have influenced this apparent change in consensus opinion. Today, it appears that professional opinion generally recommends that investors of all ages maintain portfolios that are well diversified across sizes and styles.

    In a related point, some scholars recommend that investors of all ages always tilt the stock portions of their portfolios toward value stocks. These scholars believe the additional returns of value stocks compared to growth stocks is not due to value stocks being riskier. Rather, they believe it is due to a tendency for some growth stocks to be overvalued. The related evidence may be the strongest case against the efficient markets hypothesis and, in fact, the three general investment books discussed in “Recommended Reading: Four Books That Cover It All,” [by William Reichenstein, July 2006 AAII Journal; available at AAII.com] suggest persistent value tilts. But none of the fund families in this article recommends a persistent value tilt.

    Obviously, the merits of a persistent value tilt remain an area of disagreement within the profession.

    The Fixed-Income Portfolios

    Table 3 presents more details of the families’ recommendations for the fixed-income portions of their life cycle funds. (In this section, we ignore AllianceBernstein’s allocations to REITs. That is, REITs are considered a separate asset class and are not considered part debt.)

    First, three of the families (all but Vanguard) recommend an allocation to high-yield bonds, also called low-grade, speculative, or junk bonds. These bonds have both equity-like and bond-like characteristics. It should not be surprising that high-yield bond returns and stock returns move together. For example, as GM’s prospects improve or regress it will affect prices on its low-grade bonds and common stock. In contrast, as oil prices increase or decrease, it will affect ExxonMobil’s stock price but will likely have no effect on its high-grade bonds’ prices. This illustrates why returns on high-yield bonds and stocks are more highly correlated than returns on high-grade bonds and stocks. Some scholars and professionals—but not all, as the two of us learned working together on this article—consider high-yield bonds to be part bond and part stock.

    Since three of the families recommend an exposure to high-yield bonds, it is clear that they can be a prudent asset when held as part of a well-diversified portfolio. However, if they should indeed be considered part stock, then individuals who invest in high-yield bonds will have a harder time determining their overall bond/stock asset allocations.

    Among the three fund families that hold them, all recommend that high-yield bonds represent a smaller portion of the fixed-income portfolio as individuals age. For example, Fidelity recommends that high-yield bonds represent 83% of the fixed-income portion of the portfolio for its 2045 Fund, 23% for its 2020 Fund, and 6% for its Income Fund. T. Rowe Price recommends that high-yield bonds represent 46% of its fixed-income exposure for funds with retirement dates of 2030 or later, but the exposure falls to 11.5% for its Income Fund. The pattern is similar at AllianceBernstein where they introduce high-yield bonds for mid-life savers then reduce the exposure in retirement. So, the families agree that high-yield bonds should be, at most, a small portion of the fixed-income portfolios for retirees.

    Second, there is general agreement among the families that “cash” investments should be kept to a minimum until the individual is in or near retirement.

    Historically, short-term (aka, short-duration) funds have offered higher yields than cash with negligibly higher risk. So, exchanging cash for short-term bonds has been a way to boost a portfolio’s risk-adjusted returns. Due to today’s inverted yield curve, where yields fall from three months through two years, there may be no additional return from exchanging cash for short-term bonds. If and when we return to a positive slope at the short end of the yield curve, this strategy should again pay off.




       Who Is a “Typical” Investor?
    The life cycle funds represent the profession’s current thinking about the recommended asset allocations by age for “typical” investors.

    But who is a “typical” investor?

    This was discussed more thoroughly in “Retiree Stock Allocation Recommendations: Do You Fit the “Mold?” [by William Reichenstein, February 2004 AAII Journal; available at AAII.com]. However, the key assumptions are:

    1) The investor will rely on the financial portfolio plus Social Security benefits to supply all her retirement needs; and

    2) All of the resources are intended for her retirement needs. If an individual will receive funds to finance her retirement from something other than Social Security benefits and the financial portfolio, then this could affect the target asset allocation for the financial portfolio, and the life cycle fund would not necessarily be a good fit for this individual.

    For example, if someone is receiving or will receive a monthly payment from a defined-benefit plan (e.g., company pension or military retirement) or a payout annuity, then the investor’s financial portfolio could be more heavily weighted toward stocks. For instance, a “typical” new retiree may allocate 55% of her financial portfolio to stocks. An otherwise similar new retiree who will also receive $2,000 a month from a company pension might allocate a larger portion of her financial portfolio to stocks. In essence, the defined-benefit plan is like a large “bond.” Since she has this large bond held outside her financial portfolio, her financial portfolio might be more heavily weighted toward stocks, and the life cycle fund would not be a good fit.

    The second key assumption is that all resources are intended to satisfy the individual’s retirement needs. That is, there is no overt bequest motive or other non-retirement goal. Often, this assumption will not fit a wealthy retiree. In essence, part of her portfolio may be earmarked for the next generation or a charity. In either case, the expected investment horizon is longer than the retiree’s lifetime. Everything else the same, her asset allocation should be more aggressive to reflect this longer investment horizon.

    Finally, if an individual likes the concept of a life cycle fund but prefers a more or less conservative asset allocation than available in the fund for “typical” individuals her age, then she could select a life cycle fund for individuals with an earlier or later retirement date.

    How the Thinking Has Changed

    Since life cycle funds are a relatively new phenomenon, it is not surprising that the consensus opinion has evolved through the early years. In this section, we examine this evolution of thought. The first change is that in 2004 each family had only one retiree fund. Today, they each have more than one fund for retirees. So, each family agrees that all retirees should not have the same portfolio.

    However, there remain material differences in how far into retirement each family believes it is appropriate to offer separately tailored funds. T. Rowe Price and AllianceBernstein plan to offer the most separately tailored funds. T. Rowe Price will offer separate funds for individuals at five, 10, 15, 20, 25, and 30-plus years past retirement. So, its 2005 Fund will look like (and may merge into) its Income Fund around 2035. AllianceBernstein will offer separate funds for individuals at five, 10, and 15-plus years past retirement. Fidelity says its Income Fund is designed for individuals approximately 10 to 15 years past their retirement date, so its 2005 Fund will resemble its Income Fund between 2015 and 2020. Vanguard says its 2005 Fund will become similar to its Income Fund within “five to 10 years after 2005,” but a chart shows that the merger date is expected to be 2010. Furthermore, the families agree that a retiree’s portfolio should become more conservative as he ages, but they disagree about how quickly the stock exposure should fall.

    For example, in 2006, AllianceBernstein recommended stock allocations of 60% for its 2005 Fund, 50% for individuals five years past retirement, 40% at 10 years past retirement, and 30% at 15 years past retirement. So, the stock allocation decreases by 2% per year. T. Rowe Price recommends a normal target stock allocation of 55% at retirement, 46% at five years past retirement, 40% at 10 years, 35% at 15 years, 32% at 20 years, 26% at 25 years, and 20% at 30 or more years past retirement. The stock allocation decreases by about 2% per year for the first five years past retirement, and then by about 1% per year thereafter.

    Figure 1.
    Recommended Stock
    Allocations Relative
    to Retirement Date

    In short, there is general agreement today that all retiree portfolios should not be the same, and that the portfolio should become more conservative as the retiree ages. But there remain differences as to how far into retirement each fund family believes it is appropriate to offer separately tailored funds.

    Another dramatic evolution in thought is the recommended stock allocation for a new retiree. Three years ago, Vanguard and Fidelity recommended a 20% stock allocation for their (only) retiree fund, while T. Rowe Price and another family recommended 35% or 40% for their (only) retirement fund. Today, all four families that we studied recommend that the typical new retiree have at least a 50% stock exposure. For their 2005 Funds, AllianceBernstein recommends a 60% stock allocation (including 5% from REITs), T. Rowe Price recommends 58.5% (plus an additional 7% in high-yield bonds), Fidelity recommends 50% (plus an additional 5% in high-yield bonds), and Vanguard recommends 50%. With retirement potentially lasting 30 years or longer, the consensus opinion appears to be that new retirees should have a stock allocation of perhaps 50% to 60%.

    There has also been an evolution in the thinking about asset allocation for the young. In 2004, most families recommended about 90% stock allocations for the 2040 Funds, but the stock allocations decreased consistently as the investor ages. Today, AllianceBernstein, T. Rowe Price, and Vanguard suggest that individuals maintain about a 90% stock allocation from their 20s until they are at least 40. Today’s consensus opinion seems to be that investors who are at least 25 years from retirement should have a consistently aggressive portfolio of about 90% stocks.

    Figure 1 presents the recommended stock allocations relative to retirement date at AllianceBernstein, T. Rowe Price, and from a popular rule of thumb. The rule of thumb is that to determine an individual’s stock allocation, he should subtract his age from 100. For example, for an individual who is age 65, the rule of thumb calls for a 35% stock exposure. However, the rule of thumb appears too conservative for investors of all ages. For example, T. Rowe Price’s stock allocations are usually about 25% larger than the allocation suggested by the rule of thumb before retirement and 15% larger after retirement. Although not perfect, a better rule of thumb might be to set the stock allocation percentage at 120 minus your age.

    In 2004, Fidelity and Vanguard recommended no international stock exposure for their retiree funds, while the other two families recommended international stock exposures for their retiree funds. Today, everyone except Fidelity seems to agree that international stock diversification has merit even for retiree’s portfolios.

    Furthermore, today the other three families recommend that investors of all ages maintain a roughly stable portion of their stock portfolio in international stocks. The recommended exposures to international stocks (as a percentage of the equity portion of the portfolio) are about 15% for T. Rowe Price, 20% for Vanguard, and 30% for AllianceBernstein. In contrast, Fidelity recommends about a 20% exposure until the investor is at least five years into retirement, at which time the exposure becomes about 4% and then disappears altogether.

       Asset Allocation: The Consensus Opinion
    The 4 Main Principles

    1) Stick with a fixed-weight portfolio and periodically rebalance it to maintain a stable asset allocation.
    2) Assets should include U.S. stocks, international stocks, and U.S. bonds; stay clear of international bonds, commodities, and other exotic assets.
    3) The U.S. stock portfolio should be diversified across styles (value and growth) and sizes.
    4) As you age, decrease your stock allocation.

    Allocation by Age Group

    • Ages 20 to 40: Allocate about 90% of your financial portfolios to stocks.
    • Age 40 to retirement: Decrease the stock portion steadily to about 50% or 60%.
    • During retirement: Decrease the stock allocation by 2% per year for at least the first five years after retirement; high-yield bonds should be only a small fraction of the fixed-income portfolio.
    • All ages: Maintain a stable exposure to international stocks of between 15% and 30% of the stock portfolio.


    Life cycle funds provide important insights into the consensus thinking of leading mutual fund families about the appropriate asset allocation by age for typical individuals.

    All fund families appear to agree with four investment principles.

    • There is much to be said for a fixed-weight portfolio with periodic rebalancing. A stable asset allocation produces a stable risk exposure. It will prevent the common errors of becoming too optimistic after good times and too pessimistic after bad times.
    • The portfolios should contain U.S. stocks, international stocks, and U.S. bonds. None of the families recommend exposures to international bonds, commodities, or other exotic assets.
    • The U.S. stock portfolio should be diversified across styles (i.e., value and growth) and sizes (i.e., small-cap and large-cap).
    • As people age, the stock allocation of their financial portfolios should decrease. There is a consensus of opinions in other areas.
    • Typical investors in their 20s through about age 40 should allocate about 90% of their financial portfolios to stocks.
    • From age 40 to retirement, the stock allocation should decrease steadily to about 50% or 60%. During retirement, the stock allocation might decrease by 2% per year for at least the first five years after retirement.
    • Investors of all ages, including those in retirement, should maintain a stable exposure to international stocks. The recommendations call for a stable international stock exposure of between 15% and 30% of the stock portfolio.
    • High-yield bonds should, at most, be a small fraction of the fixed-income portion of retirees’ portfolios, but may play a larger role before retirement.

    Although the recommendations are only appropriate for “typical” investors by age, we believe most individuals will be able to benefit from studying the current thinking at these respected families of mutual funds.

    The opinions included are those of the authors and not necessarily those of the U.S. Air Force Academy, the U.S. Air Force or any other federal agency. The authors thank Jerome Clark of T. Rowe Price for data and comments.

    William Reichenstein , CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University and is head of research at Social Security Solutions, Inc .
    William W. Jennings CFA, is a professor of finance and investments at the Air Force Academy.


    Daniel Bikle from CA posted 3 months ago:

    Although briefly alluded to, many older investors have defined benefit plans/annuities and need to consider these as bonds. What should have been discussed is how to determine the "bond" value of DBPs and annuities for determining allocations among the investment categories.

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