Go the LifeCycle or Target Fund Route?

Don't know how to invest? You or your progeny got better things to do than worry about retirement and building a nest egg? The mere mention of asset allocation give you a headache?

No problem - choose a lifecycle or target date fund and leave the driving to someone else. At least that's a bit of advice widely proffered by both financial planners as well as fund providers. The lifecycle/target date funds do the asset allocation and rebalance over time. What's not to like? Well, the fee for one thing. So let's get out some Excedrin and take another look

Consider the Fidelity Freedom 2050 Fund (FFFHX), a typical recommendation for, say, a 25-year-old who doesn't want to make fund choices. The 2050 fund charges .84%. Put monies into the fund out of every paycheck for the next 39 years, and it will take care of the whole kit-n-kaboodle - at an expense of .84% of the market value of assets each year.

What's the alternative? One possibility is to mimic the basic asset allocation of the 2050 fund. By going to the summary sheet, you can easily find the fund's composition. For example, the fund holds 55% domestic equity. This can be mimicked with the Spartan Total Market index fund (FSTMX) - expense ratio .10%. The 2050 Fund holds 24% in the international equity sector - mimic with FSIIX - expense ratio of 20 basis points. Similarly with bonds.

This portfolio so constructed will have an expense ratio of between .10% and .20%, which, over a long period of time, makes a difference compared to the .84% expense ratio of the 2050 fund. The alternative portfolio will be a bit different from the 2050 Fund because it won't contain some parts of the 2050 fund - like the commodity, the emerging countries, or the high yield bonds sectors. These can be picked up at a later point with monies invested outside the 401k - in a Roth, for example.



Finally, the fund composition should be checked yearly to examine changes in composition. Over time, the portfolio will get more conservative by shifting from equities to fixed income.

This approach produces a slightly different portfolio as mentioned above. The bet is that the differences won't produce materially different performance. In fact, the wailing and gnashing of teeth by the investment community recently over the correlation among asset class returns suggests this could be the case. In any event, the cost is materially reduced with a portfolio costing approximately 15 basis points/year versus 84 basis points/year.

It may  pay to sit down with a professional, pay them an hourly fee, and get set up. I would even start with your 401k rep if interested in going this route - either way it should minimize any resulting headaches.

Disclosure:  This information is for educational purposes only. Investors should consult with professionals and do their own research before investing.

On Lifecycle funds...

I am ambivalent on lifecycle funds. I like the idea that many 401k plans automatically opt-in new employees and put them in a lifecycle fund that changes asset allocation over time. Asset allocation is the single most important decision required of  new investors, and it can be the hurdle that they fail to get over. What percent of my assets do I put in stocks and what percent in bonds? Lifecycle funds solve this problem.

Research and actual participation evidence shows the opting-in feature significantly increases participation in retirement accounts--which is important. I guess it also proves that many people are too lazy to check a couple of boxes and sign the bottom line, but that's a whole new subject area.

Also, I see the value of lifecycle funds as an investment vehicle for those who just don't want to be bothered thinking about investments. Those caught in the headlights can just buy the lifecycle fund and stick with it. It is a lot better than wringing your hands and procrastinating on the savings program. With lifecycle funds. there is absolutely no excuse for not starting a retirement savings program.

The lifecycle funds are intended, of course, as an investment for all assets. Many people don't understand this and pick them as an investment choice among several other fund--which doesn't make sense.

The main drawback of lifecycle funds is that they are a one-size-fits-all solution. Unfortunately, investors come in different sizes. In other words, for example, all 65-year-olds aren't the same. Some have concerns about running out of money and need to be a bit more conservative. Some are flexible and are willing to take on additional risk to achieve their financial goals. Others have sufficient assets and running out of money is not a concern. Their primary goal is leaving assets for heirs and for charities. They have the capacity to take on more risk in search of higher expected returns.

The bottom line is that, IMHO, lifecycle funds are a good starting point for thinking about asset allocation. If a person's goals are pretty much in line with the average investor and the volatility of the fund has been examined and is acceptable, then it is a good, easy way to go. If these conditions aren't met, then it makes sense to do a bit more research and learn how to tailor a program to align with specific needs and goals.