By Jeff Headrick, Financial Planner
Are lifecycle funds a good investment? How do they work? When should I use lifecycle funds in my portfolio? In this month’s post, I will share with you some thoughts that will shed some light on these seemingly simple, but all too often misunderstood investment strategies.
What are Lifecyle Funds?
Lifecycle funds, also known as target date funds, are designed to be an all in one portfolio for investors at various stages in their lives. They have cool numerical names like the 2025 fund, the 2030 fund, the 2040 fund, etc. From American Funds to Vanguard to Fidelity, I cannot think of many big-name investment shops that don’t carry a smorgasbord of these funds.
Conceptually, lifecycle funds are easy to grasp. They are marketed to investors with a glide path methodology that takes some of the constant thinking out of the equation. But are lifecycle funds a good investment? Read on to learn more.
Hypothetically, let’s say that you are a pre-retiree age 57 in 2019. You plan on working until age 67 so that you can retire right about the same time that you start drawing full Social Security. Knowing you only have about 10 years to go, how would you allocate your life savings? Would you select eight or 10 different ETFs and mutual funds and design your own portfolio from scratch?
Or would you be attracted to a lifecycle fund with a set it and forget it feature that more or less manages itself?
How Are Lifecycle Funds Used?
I think that the original intention of lifecycle funds was to simplify and diversify America’s retirement savings. Generally speaking, most individuals, even very intelligent individuals with a degree or two, tend to have a difficult time with the investment selection process. If you struggle in this area trust me when I tell you that you’re not alone.
Ideally, investors usually have several options with their 401(k). There are all sorts of laws and rules that usually apply, and most 401(k) providers can’t just offer you one or two or three investment choices. They typically have to offer several.
When prospective clients meet with us to review their 401(k), they typically have the following options available to choose from (or something very similar to it):
US Large-Cap Stock Fund
US Mid-Cap Stock Fund
US Small-Cap Stock Fund
US Bond Fund
International Stock Fund
Money Market Fund
With these six segments (funds) of the market you can typically build a very nice portfolio. However, you need more than a 30-minute meeting with HR and a 20-page investment guide to figure out how to go about it.
More often than not, I meet with people on a regularly basis that are managing substantial portfolios on their own, with very minimal guidance from their employers.
And please don’t think that I am harping on the employers. Sure, employers could do a better job when it comes to investor education. But as educated investors, we’ve all got a be continually sharpening our saw in this area. Our financial livelihood depends on it.
Let’s get back to the drawing board. Many years ago 401(k) designers and employers realized that having everyone design their own portfolio was too tall of an order for some. So, they began designing lifecycle funds that were built to run like clockwork within certain parameters.
Vanguard Target Retirement 2030 Fund (Lifecycle Fund)
For instance, if someone in 2019 chooses a 2025 fund, it is thought that they will be retiring in about six years (time is the parameter). Or, if someone has about 11 years until retirement, he or she might select the 2030 fund. In theory it makes sense, and that’s why employers and regulators love it. However, reality is different than theory, and sometimes these funds work well— but all too often they don’t.
When Should You Use Them?
These days I see 401(k) providers that still offer the same six asset classes shown above. However, more and more, I am seeing a splash of several lifecycle funds (also known as target date funds) added to the investment options available to employees. I believe the intention is to either:
- Construct a portfolio using the traditional asset classes like US large-cap, US mid-cap, US small-cap, international stock, US bond, and money market.
- Skip doing your own portfolio construction and simply choose one of the lifecycle funds.
Again, in concept I think this is fantastic. But here is where I have a problem. All too often, I see clients that are using both strategies. They are selecting some of the more specified holdings based on whatever criteria they like, and then adding one or more of the lifecycle funds in conjunction. This is where I get a little unsettled.
While there may be some radical rationale that I’m not aware of for blending the two strategies, I’m pretty sure that in general this is a bad idea. You get an overlap of bond holdings when you do this, as well as an overlap of stock holdings. You also confuse the understanding of your bond to equity ratio because you’ve combined (mixed) the two strategies. In doing so, a lot of the simple math becomes, well, not so simple. Why not just choose one or the other? If you can rationally explain this, maybe your OK. But if not, maybe it’s time to reallocate.
Are Lifecyle Funds a Good Investment?
I think lifecycle funds (also known as target date funds) can be a great investment. However, I believe they work best for people who have a limited understanding investments, and are ready to fully commit their allocations to such a strategy. Commit means that you don’t water down your investment path with other investments. You keep it simple and straightforward.
I will admit that this is a tricky topic. I highly encourage just about everybody these days to find a financial advisor or a financial planner that you can trust, and to work with them on an ongoing basis to make sure your retirement plan is running like a new Toyota. (If you have never worked with a financial planner, please read our Beginner’s Guide to help you in the process.)
Like that Toyota, every vehicle needs attention, every vehicle needs maintenance, and those who care for them the best-- tend to get the most mileage out of them.
If we can help you in anyway, please let us know.
We can be reached at (910)448-1450, or you can click here if you’d like to schedule an initial conversation.
About the Author
Jeff Headrick is an independent financial planner and wealth manager with Inspire Financial Planning. When Jeff was still in his teens his father died unexpectedly. While his father was a hard worker and a good provider, he did not have the best financial plan in place when he died.
This left his family at a tough financial crossroad. This personal experience, coupled with being inspired by Sir John Templeton, Warren Buffett, Dave Ramsey, and the laws of compound interest, prompted Jeff to enter the financial services industry in 1999. He has been helping people with their financial planning ever since.
Jeff lives in Wilmington, NC with his wife and two children. He spends most of his spare time just across the Intracoastal Waterway in Wrightsville Beach, enjoying the beauty of the NC Coast.
Charts and graphs contained herein should not serve as the sole determining factor for making investment decisions. All hypothetical scenarios are for illustrative purposes only.
Investment Advisory Services offered through AlphaStar Capital Management, LLC a SEC Registered Investment Adviser. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.
Diversification does not guarantee profit nor is it guaranteed to protect assets. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
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