What you need to know about life cycle funds
Like the college student who refuses to consider his impending entry into the labor market, many Americans take a head-in-the-sand approach when it comes to retirement planning. They don’t contribute enough to 401(k) plans, and they don’t periodically rebalance their investments to protect contributions and generate a reasonable rate of return.
One recent solution to this dilemma is the advent of life cycle or target date funds. Also called age-based funds, these funds contain holdings in other mutual funds. In other words, they’re “funds of funds.” In some cases, firms automatically contribute a portion of an employee’s salary to the company retirement plan, and life cycle funds are the default depository for such contributions.
If you’ve set aside money in a 529 savings plan for your child’s college education, you might be familiar with the concept. When an employee is just starting out, the target retirement fund might invest 80% of its assets in stock-based mutual funds and only 20% in more conservative funds. As the employee progresses toward retirement, the mix changes. A life cycle fund for an employee in his 60s might invest 60% of its assets in bonds and other relatively conservative investments, while only 40% might be allocated to stock funds. Life cycle funds put portfolio rebalancing on autopilot. The fund manager tracks the allocation of stocks and bonds, and makes adjustments as needed to meet predetermined investment objectives based on target retirement dates.
Although putting your retirement investments on autopilot might sound like a great idea, this approach also has some significant drawbacks. For one thing, contributing to a garden variety index fund may be cheaper because you don’t have the expense of managers who periodically rebalance your investments. Also, including a life cycle fund in a broader investment portfolio may make it difficult to determine your asset mix at any point in time. If you know, for example, that your 401(k) is invested in a Standard and Poor’s 500 index fund and a fund consisting solely of U.S. Treasury bonds, it’s relatively easy to know how much of your money is invested in stocks and bonds. Adding a life cycle fund to the mix, with its fluctuating holdings of more-or-less conservative and risky investments, can muddy the waters and make portfolio management tricky.
Still, life cycle funds may make sense for you. Just be sure to verify that your autopilot is still on course.