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Life Cycle Funds

by Cara Scatizzi

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Life cycle funds are marketed as a maintenance-free way for individuals to invest for retirement. They were created under the assumption that many individuals needed a one-stop investment vehicle that properly rebalances their portfolios over their investment lives, as their investment needs change. Typically, in an individual’s younger years, riskier but higher-return potential assets should be emphasized, but as the individual approaches retirement, the percentage commitment to these types of investments should be gradually reduced. Life cycle funds are designed to follow this investment pattern.

At first, life cycle funds were limited to mutual funds, but over the years, life cycle exchange-traded funds ETFs have been created.

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About the author

Cara Scatizzi is a former associate financial analyst at AAII.
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How It Works

Life cycle funds are designed to be a “set it and forget it” type of investment. You pick a fund based on your expected retirement age or risk preferences and, theoretically, do not have to take any action, or perhaps only a small action as you near retirement. Life cycle funds have fixed allocations based on either a target retirement date or risk preference, meaning you do not have to actively rebalance your portfolio.

Types

There are two types of life cycle mutual funds: those based on a target retirement date and those based on targeted risk.

Target Date Funds

This type of fund is created based on a target retirement year and its asset allocation changes over time. It is a fund of funds, meaning it invests in a basket of mutual funds to meet allocation objectives.

The further away the target date is, the more risky the assets that are included in the fund. As retirement approaches, the portfolio assets are moved into less risky options; once the retirement age has passed, funds are mostly in income-earning fixed-income investments and cash.

Each fund family has its own asset allocation plan. In general, target date funds start out with about 90% invested in stock mutual funds (domestic and international) and 10% in cash and bond funds. This allocation remains relatively steady until the target retirement date is about 25 years out. The fund then slowly moves out of equity funds and into more fixed-income funds until it reaches the target retirement date with an allocation of about 50% in stock funds and 50% cash and bond funds. The fund continues to move to more fixed income and short-term income mutual funds throughout retirement.

These are general guidelines that differ by fund family and each fund. You can read about target allocations in a fund’s prospectus. The managers will stick to the target allocations as well as they can. Be aware that allocations vary from fund to fund.

As an example, let’s compare three 2020 life cycle funds. Vanguard’s Target Retirement 2020 fund is currently invested about 69% in stocks and 31% in bonds. Fidelity’s Freedom 2020 Fund is invested about 63% in stocks and 37% in bonds. Finally, the T. Rowe Price Retirement 2020 Fund is invested in 81% stocks and 19% in bonds and cash. In addition, levels of domestic and foreign stocks as well as short-term and longer-term bond funds vary from fund to fund. You can see that with 11 years until the funds reach the target retirement year, they are varied in allocations.

Target Risk Funds

Sometimes called active life cycle funds, target risk funds are based on risk tolerance and are typically broken down by aggressive, moderate and conservative asset allocation strategies. This type of fund requires that you move from an aggressive to a more conservative fund as retirement nears. Portfolio managers will give a wide range of target allocations for various asset classes and they have the freedom to decide, based on current market conditions, the exact allocation. This type of fund is more active than the “set it and forget” attitude you can have with a target date fund.

Life Cycle ETFs

Somewhat new to the scene are life cycle exchange-traded funds ETFs. ETFs are baskets of securities that trade intraday on an exchange. In 2007, the first life cycle ETFs were introduced, and many have followed since. These ETFs mimic the target date mutual funds and are designed to automatically scale back risk as the investor gets closer to the target date, typically by selling stocks and buying income-producing bonds.

How to Trade

Some of the most popular mutual fund families offer these funds (Vanguard, T. Rowe Price and Fidelity) and most companies offer these funds in 401(k) retirement plans.

Exchange-traded funds are traded like stocks on an exchange; life cycle exchange-traded funds can be bought and sold from most brokers.

Investor Suitability

Life cycle funds are useful for investors who do not wish to or are unsure of how to rebalance their portfolios on a regular basis. The allocation strategies generally match typical advice in regards to retirement investing. You should compare various funds to see how the actual allocation matches with the stated target allocations and always check the fund’s performance, turnover and fees.

Tax Consequences

Tax rules for the life cycle mutual funds and ETFs are the same as any mutual fund or ETF. If you invest through a Roth IRA or tax-deferred retirement plan, the tax rules governing the retirement plan apply.

The Pros

Set It and Forget It

Life cycle funds do not require much effort once the initial investment decision has been made. If you choose a target date fund you do not have to rebalance or worry about changing allocations as your retirement nears.

Target risk funds do not require any rebalancing but will require you to switch from a more aggressive to conservative strategy as you get closer to retirement.

The Cons

ETF Commissions

ETFs generally have lower expense ratios compared to mutual funds. However, there will be commission fees associated with each trade.

Fixed Allocations

The allocations are decided by the fund family and fund manager. Allocations can vary by fund family, individual fund and each fund manager. These are not funds for people who like to control the allocation of their investments or want to change allocations as the market changes.

Additional Information

AAII

www.aaii.com

AAII offers a number of articles about life cycle funds. “Choosing the Right Mix: Lessons From Life Cycle Funds” by William W. Jennings and William Reichenstein appeared in the January 2007 AAII Journal and “Allocation Over Time: Life Cycle Mutual Funds” by John Markese appeared in the November 2004 AAII Journal. You can find these articles using the Search box on the AAII homepage or by going to www.aaii.com/journal and searching for the appropriate issue.

Investopedia

www.investopedia.com

Investopedia is a free educational financial Web site. The site offers a wealth of data and articles on various investing topics including life cycle funds. Specifically, “The Pros and Cons of Life-Cycle Funds” and “Target Your Retirement With Life-Cycle ETFs” by Lisa Smith offer useful information.

Vanguard

www.vanguard.com

Fidelity

www.fidelity.com

T. Rowe Price

www.troweprice.com

Vanguard, Fidelity and T. Rowe Price offer a number of target date and target risk funds. You can research the funds, view performance, compare the actual asset allocation with the target and read the prospectus of any fund.

Cara Scatizzi is a former associate financial analyst at AAII.


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