NEW YORK — Life-cycle funds that are becoming increasingly popular are meant to make retirement planning easy. But that's not how investors have been using them, mutual fund companies say.
The reality, according to a Vanguard study titled "How America Saves 2005," is that while the funds offer complete diversification in one investment vehicle, many participants use life-cycle funds as "just another part of their overall portfolio."
Life-cycle funds allow an investor to pick a fund aimed at his or her intended retirement year. The idea behind the funds is that investors tend to do a poor job of diversifying and rebalancing their portfolios as they approach retirement, so the fund will do it for them, starting with an aggressive mix of equities and bonds in the decades before retirement and rebalancing, often daily, to maintain diversification.
The funds become more conservative as retirement nears, selling stocks and buying bonds. They're meant to be an all-in-one solution for retirement, offering complete diversification in a single fund.
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It's an idea many investors have found appealing. In 2004, the last year for which numbers are available, about six in 10 employer plans run by the Vanguard Group Inc. offered life-cycle funds. Fidelity's Freedom line of life-cycle funds has grown 248 percent over three years, to $45.9 billion as of Jan. 31.
Compounding the problem of consumers' using a life-cycle fund as one of several investments is the fact that people continue to do really foolish things with the rest of their portfolios.
Vanguard found that 29 percent of people who invested in the funds as part of their company's retirement benefits used the funds as intended, as an all-in-one investment. Another 49 percent invested in a life-cycle fund and one or more stock funds.
The third group of life-cycle fund investors appeared to take what Vanguard calls "a naive approach," investing in multiple life-cycle funds.
One possible explanation is that participants view the life-cycle funds as a low-risk option, Vanguard's report said. Another explanation is that participants don't understand the diversity of holdings in a single life-cycle fund, so they buy funds with multiple retirement dates in an effort to diversify.
"Ironically, one of the principles of sound investing that Americans have taken to heart may also pose a hurdle to life-cycle funds: the notion that one should never 'put all their eggs in one basket,' " a description of the funds on Fidelity's Web site says. "With additional education, investors should be able to understand that this clearly doesn't apply to a life-cycle fund that may include dozens of underlying mutual funds holding hundreds or even thousands of individual securities."
The problem, as Fidelity explains it, is that "life-cycle investing can only really do the job for investors if it is used as the core strategy for most of the assets being earmarked for a given goal. Allocating a small portion of assets to a life-cycle investment program will neither provide the diversification nor the age-appropriate risk exposure that is so critical to this way of investing."
Fidelity's advice for investors in life-cycle funds is to invest the bulk of their assets in a fund targeted for their retirement group, then use the small portion left to play with.
A recent Lipper study compared life-cycle funds from AllianceBernstein, Fidelity, T. Rowe Price and Vanguard. Using a simulation of the companies' allocation plans, how each is expected to change over a life-cycle fund's lifetime and 40 years of market returns, the simulation found that AllianceBernstein's offering was the leader.
One of Lipper's theories for why AllianceBernstein's funds did so well in simulation: They included fewer investment classes in their allocations. In short, the allocations were simpler.