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.
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.
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Filed Under: Investing
About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.