Spinning Their Wheels

If you're thinking of steering your clients into lifecycle funds, be sure to kick the tires first. With more and more asset managers rolling out lifecycle funds — funds pegged to an investor's specific retirement year or based on a risk profile — it's easy to get caught up in some excitement. But, buyer beware: They can be expensive and have middling performance.

Still, right now, lifecycle funds are the hottest product on the market. And for good reason: Their all-in-one, set-it-and-forget-it structure, instant diversification and periodic rebalancing offer investors a simple way to save for retirement without having to do any of the heavy lifting. The funds often contain a mix of stocks, bonds and money market instruments in a single offering that is more aggressive when you're younger and gets more conservative as you approach retirement.

Advisors were at first reluctant to offer such a pre-packaged product (the client might wonder: “What is he doing for me again?”). But, many quickly realized the funds of funds allowed them to focus on gathering assets rather than on building portfolios. Further, advisors like that they're easy to explain to clients, particularly target-date funds, which are named after the year in which the client is set to retire. “They've made it easy for investors. That's the bottom line,” says Jeff Tjornehoj, senior analyst at Lipper. In a world flooded with product choices, lifecycle funds enable advisors to narrow down a pool of thousands of funds from which to choose, he says

Indeed, their user friendliness have made lifecycle funds the new darlings of the defined contribution space. But even outside 401(k) plans, advisors have been plugging them into client portfolios, albeit at a slower pace. “Advisors are embracing them. Their ears have perked up,” says Shauna Ginsberg, research analyst at Financial Research Corp. Target-risk funds have been more popular among advisors, because there is a perception that they allow for more of an opportunity to deliver advice. FRC says that 40 percent of target-risk fund sales are associated with defined contribution plans, as compared to 70 percent of target-date funds. (Target-risk funds differ from target-date funds in that they don't assign a retirement date as rigidly; rather they are defined more broadly, from aggressive to moderate to conservative.)

Either way, they have certainly generated an impressive amount of interest. Target-date and target-risk funds together represent the fastest growing products on the market. Assets held in these lifecycle funds have ballooned to $255 billion as of July, from $106 billion in December 2003, according to FRC. Year-to-date net flows to lifecycle funds tallied $33.7 billion at the end of July, eclipsing flows of $32.7 billion for all of 2004, FRC says. FRC analysts are projecting a compound annual growth rate of 23 percent over the next five years. “A large part of that growth can be attributed to scars from the claws of the bear market,” says Tjornehoj.

A decade ago, when Fidelity Investments first launched its Freedom Funds — the first lifecycle funds on the market — advisors weren't keen on these products because the market was hitting on all cylinders. “It was really an uphill battle with technology flying high. Investors were very sector oriented,” says Paul Neuner, a top producer at A.G. Edwards in San Diego who uses lifecycle funds in the defined contribution plans he sells to business owners.

But Fidelity proved to be ahead of its time as these funds eventually flourished in the wake of the market crash. Fidelity has since dominated the landscape, gathering nearly $65 billion in assets. Even with newer entrants coming out of the woodwork all the time, Fido still has 25 percent of industry assets while Vanguard remains a distant second with 14 percent of assets. (Rounding out the top five: John Hancock, holds 7 percent, T. Rowe Price 6 percent and WM Group has 5 percent.)

But, like anything else, not all lifecycle funds live up to the hype. Some of these pre-packaged portfolios come with hefty price tags. Many of them have little exposure to small- and mid-cap stocks or can straddle a benchmark so closely that they resemble index funds. Suitability can be an issue as well since the fund-of-funds structure often lends itself to allocations holding purely proprietary funds, which may not always be the best choice for the client.

Target-date funds are also criticized for painting people of the same age with the same broad risk brush. Not everyone of a similar age has the same risk tolerance. It also doesn't factor in life “events,” such as, say, losing a job or earning a law degree at the age of 35 or being a single mother with no higher education.

Other lifecycle funds — particularly those purchased outside of a 401(k) plan — also have the potential to generate a hefty tax bill for shareholders when it comes time to liquidate the fund at retirement. For these reasons, advisors should take caution before jumping on the bandwagon.

Much like any other investment product, comparison shopping is crucial. Many lifecycle funds are expensive, because there is an extra layer of management, an inherent burden of investing in funds of funds. State Farm's Life Path 2030 B Legacy fund, for example, carries a 1.70 percent expense ratio, well above the industry average of 1.47 percent for U.S. domestic equity funds, according to Morningstar. In addition, the underlying funds are predominantly index funds, which investors can get cheaper at Vanguard or Fidelity. Putnam's Retirement Ready 2050 fund, for example, imposes a 1.22 percent expense ratio for a bucket of Putnam's proprietary funds, which don't have a very compelling performance story. The SunAmerica 2010 High Watermark Fund is the most expensive one on the shelf, carrying a 2.3 percent expense ratio.

Even Fidelity, which has much more modest fees, jams every one of its Freedom Funds with the Fidelity Advisor Dividend Growth fund, which, despite strong performance in recent months, has a poor long-term track record. Russell, on the other hand, has no proprietary funds in its lifecycle funds, but can hurt you with its steep prices. Its Russell Life Point 2040 fund charges 1.51 percent of assets. “Investors shouldn't pay more than 1 percent for a lifecycle fund,” says Greg Carlson, senior research analyst at fund tracking firm Morningstar.

Another common problem with these funds is that they're heavily weighted in large-cap equities. Many of them have more than 75 percent of their holdings invested in large-cap stocks. Not to pick on Fidelity, which has a strong lineup of funds, but its Fidelity Freedom 2030, 2035 and 2040 funds each have more than three-quarters of the portfolio invested in large-cap stocks. “They need to do a better job of allocating,” Neuner says, who seems otherwise pleased with Fidelity's lineup. Craig Israelsen, associate professor at Bringham Young University's School of Family Life, agrees, “They should be quite a bit more willing to expose themselves to small- and mid-cap returns.”

A bigger problem: How do you benchmark a lifecycle fund's performance? A common benchmark is the Standard & Poor's 500 stock index, comprised of large-cap companies. But Israelsen argues that it is not fair to compare the performance of a target-date fund, which holds a mix of cash, U.S. stocks, non-U.S. stocks, bonds and other securities to the performance of a 100 percent equity index.

Some advisors say that they will never use lifecycle funds, because they pride themselves on their ability to develop an asset-allocation model for their clients and would be hard-pressed to justify their fees if they used pre-packaged portfolios. And since the approach effectively locks the investor into a preset schedule, the decision to use them minimizes the need for additional advice, thereby making the advisor expendable. Not to mention outside of a 401(k) plan, investors can choose a lifecycle fund on their own without having to pony up the advisory fee. And if some of these funds are really just closet index funds, clients can get that same level of diversification for far less through a Vanguard index fund charging less than 20 basis points.

So how are advisors using them? Some advisors are using them as part of core-satellite strategy in which the lifecycle fund is the core holding, making up more than two-thirds of the portfolio so as to achieve maximum diversification and risk control. With the lifecycle fund serving as the anchor, the advisor then picks the other investments to complement it.

With wirehouse reps increasingly going after the ultra high net worth, these products are a perfect fit for their lower-end clients, who are being shipped to call centers. A packaged product like this enables the advisor to leverage his time and avoid getting bogged down putting together asset allocations for small-fry clients.

So far it looks like advisors at regional b/ds are most enthusiastic about the funds: They comprise 29 percent of third-party lifecycle fund sales. RIAs/financial planners are the next largest group, with 22 percent of sales. Bank sales make up 18 percent while direct-to-investor sales chip in for 14 percent. Wirehouses combine for only 7 percent of sales. Overall, 45 percent of all target-risk funds are sold through an advisor. Target-risk fund sales tend not to be tied to production level or years of experience, which suggests very broad distribution. Target-date funds, however, are geared specifically toward advisors focused on defined contribution business, advisors in the independent or RIA channels and advisors with $1 million in production or at least 20 years of experience.

Evidence shows that investors are not using lifecycle funds properly, opening the door for advisors to add value. A study conducted by Hewitt Associates showed that the average 401(k) participant has only 6.4 percent of his assets in a target-date or target-risk fund. That runs contrary to its intended usage which is that it serve as a core portfolio holding. This illustrates the need for investment advice and presents an excellent opportunity for an advisor to do a little hand-holding.

Top-performing lifecycle funds (target-date) over the last three years.