Lifecycle Funds: Look But Don't Touch

Lifecycle or target date funds are becoming more popular in retirement accounts. They provide a very easy way for investors to create a broad diversification of investments and an appropriate asset allocation for their age that rebalances accordingly. While they can be very helpful to investors, some people are not using them properly and could be doing more harm than good.

Leave Them Alone

To be as effective as possible these funds need to encompass an individual’s retirement portfolio almost in entirety, and it shouldn’t be disturbed or messed with. These funds are designed to take the work out of fund selection, determining the balance between fixed income and equities, and rebalancing and changing the investments as you age.

Many people just can’t leave them alone and have to make changes to their accounts, which may not be the best idea if you are relying on a lifecycle fund. For some people this means buying other funds in addition to the lifecycle fund, and for others it means owning multiple lifecycle funds or frequently trading in or out of the fund. In either situation you may be hurting your overall investment without realizing it.

The Problem With Overlap

When a retirement plan provides various lifecycle funds they are generally held through the same fund family. This means that a 2015 fund vs. a 2020 fund may have virtually the same underlying investments and only a slightly different distribution of the assets. So if your portfolio consists of 50% in a 2015 fund and 50% in a 2020 fund you are likely overlapping the majority of your total investments and only noticing a very small difference.

You don’t even need to own two different lifecycle funds in order to overlap your investments. Someone who owns a lifecycle fund yet purchases other mutual funds is likely to be simply overlapping what they already hold. It is a pretty safe bet that a 2030 lifecycle fund will have its fair share of large cap stocks in it, so if you purchase additional shares of another large cap mutual fund or ETF you really aren’t adding to your diversification at all, simply becoming overweight in some companies.

Of course that isn’t to say you should only buy one lifecycle fund and be done with it, but you do have to be aware of the overlap that can be caused by owning multiple funds. It may make perfect sense to purchase another mutual fund that specializes in a specific industry or otherwise fills a niche in your overall investment picture. Just be sure you understand what you are holding before simply buying another fund.

Asset Allocation

While overlap is a problem, an even larger issue comes in the form of skewing your overall asset allocation. This is where it pays to have a solid financial plan that you monitor and update regularly. For many people their retirement plan through work may be the largest, but only one of many different accounts. A lot of people have a 401(k), a Roth IRA, maybe a traditional IRA or even substantial savings. All of these assets make up your complete investment picture.

Many people forget about the other accounts and when creating their allocation they do so based on that particular account. They may be in a position that a mix of 90% stocks and 10% bonds/cash is appropriate, yet they are really at a 70/30 mix when taking into account all investments. For example, lets say you have the accounts below:

  • 401(k): $38,000 (Invested in a 2030 lifecycle fund, 90% stock 10% fixed)
  • Roth IRA: $14,000 ($8,000 in various large-cap stock, $3,000 in a bond index, $3,000 in an international fund)
  • Traditional IRA: $3,500 (S&P 500 index)
  • Savings: $12,000(high-yield savings)

For most people they look at their primary retirement account and for this person they would think that their lifecycle fund is right on track because it is a fairly aggressive mix of 90/10 and is the bulk of their assets. But when you look at all of the other assets, which again the IRAs are certainly weighted toward equities the overall allocation is much different. The true asset allocation for this person is 72% stocks and 28% fixed income. For someone who has more than 20 years until retirement this allocation is not as heavy in equities as it may appear when looking at the accounts individually.

I know this is an oversimplified example, but the point is that most people have more than one account with all of their investments in it. And even if you only invest in a single lifecycle fund in this account you have to be careful that your other investments outside of this account compliment your target allocation instead of sabotage it.

Look But Don’t Touch?

With this statement I am not implying you should avoid these funds, not at all. These are a terrific way for investors to spread their money out with little effort and require very little interaction with the funds. I think these funds are turning out to be a great addition to retirement plans everywhere, but they have to be used properly in order to be effective.

When I say don’t touch, I mean pick one and leave it alone. In the retirement plan I work with directly I see participants regularly micro-manage these investments. Some will trade in and out of them once a year or more, while others will own up to 4 different lifecycle funds, and some will even own 50% of a lifecycle fund and throw the rest into another fund that almost entirely overlaps what they already own in the lifecycle fund.

The bottom line is that these funds can be great, but make sure you are aware of their role in your portfolio and invest accordingly. If you are someone who likes to tweak and fiddle with your investments, you may be better off creating your own portfolio and managing it appropriately. If you do want to utilize the ease of use that can come with these funds that is great, but make sure you take into account your other investment holdings to ensure that it is truly benefiting you the most.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

6 comments
Theresa
Theresa

Jeremy,
I am 45 and plan on retiring at 67. I work for the Federal Government and right now I have a TSP Account of about 43,000. It is split equally in percentage between a G, C, S, and I Fund. I was thinking of taking the G and C and putting that 50% into a 2030. I know absolutely nothing about investing and this is the only investment in my retirement besides what I will get monthly when I retire through the VA and Social Security. Do you think this is smart or am I overlapping too much? I am only investing 5% at the moment but would like to increase to 10% in the near future. Can you give me any advice?

Andy
Andy

It's problematic to count savings as part of your overall asset allocation. If you have some expense (say, a car) that uses up $10k of your $12k savings, you would have to sell some amount of equities to rebalance.

And many people save for the short to mid-term as well. In that sense 70/30 may not be aggressive at all.

broknowrchlatr
broknowrchlatr

My case is similar to Adam's

In my 401k, the options are average. I have about $35k in T.ROWE PRICE 2040 (TRRDX). They have other T.ROWE PRICE life-cylces at 2010, 2020, and 2030. They have a few good emerging markets funds and one good Vangaud Equity index. I have about $10k in those other finds.

Outside the 401k, I have about $40k in IRAs. Part of that ($20k) is still in TRRDX (I rolled it over from 401k). But, there is another $20
$8k Small cap
$8k Mid Cap
$4k International

So, I am simply taking the best option in my 401k and then using other funds to weight it more toward the areas I want more exposure to. TRRDX is a solid performing fund. But, it just doesn't have the mix I want. So, I make that correction. As wit ADAM, I don't touch the lifecycle fund.

Jeremy
Jeremy

Adam, in your case I think this works quite well. Like you mentioned, you have a core holding and don't touch it and then actively manage some more specialty areas such as international and emerging markets.

The key is that you understand the role of the lifecycle and realize there is some overlap while still investing accordingly.

Unfortunately many of the less sophisticated investors who are using these funds don't really understand the underlying investments and can really mess up their portfolio.

I'm with you though, I have a large core holding of an asset allocated fund and then use part of my portfolio for more active investing or experimenting with more specialty type of investments to fill some of the gaps.

Adam
Adam

Good post, I agree that Lifecycle funds are great additions to retirement plans and especially for people with little investing knowledge they should be the default.

In my case I want to be able to improve my rate of return slightly by shifting around my investments. So I but 50% of my 401k into a Lifestage and I don't touch it. With the other 50% I more actively invest it, currently weighted towards emerging and foreign markets and small-cap stocks. I know there is some overlap but I'm willing to accept it.

Right now I have:

401k (Retirement with 80% of total)
50% Lifestage 2045
10% TRP growth stock
10% DPIEX
10% GMCEX
10% RERFX
10% Bond fund

ETFs (Lazy Portfolio with 15% of total)
33% VTI
33% EFV
33% VIPSX

I guess I'm willing to take advantage of Lifestage funds but also want to be able to "touch" others. :)

Jeremy
Jeremy

Theresa, it's hard to say without knowing the makeup of the funds, but generally speaking the target date funds are just going to consist of a stock index and a collection of bonds to create a suitable mix for your age. So if you already have stocks and bonds in the rest of the portfolio the target fund is just going to largely have the same investments and just cloudy your true asset allocation a bit. So because you'd still have money in the S and I funds along with the 2030 your total asset allocation would be weighted heavier on stocks as a whole. Not that there's anything wrong with that, but if your idea was to closely match what the 2030 looks like then having the additional funds wouldn't accomplish that.