The Time of Your Life
[January/February 2008]
Life cycle funds gain popularity by
enabling investors to choose tailored
investment plans
By Allen Kenney
The time-honored mantra of retirement planning advises, “tailor your retirement portfolio to match your age and tolerance for risk.” However, many investors have learned this is much easier said than done.
For instance, when exactly are you supposed to start shifting your allocations from equities to fixed-income instruments? How much are you supposed to move? How often? Then there are the everyday questions, such as who is going to remind you when it’s time for the annual check-up with your financial planner?
That’s where life cycle funds come in. These no-fuss funds have seen an explosion in popularity in the last decade, and their managers are increasingly turning to publicly traded real estate securities to help round out portfolios.
Set Your Retirement on Autopilot
After roughly 10 years on the investment scene, life cycle funds have become known by many names, such as target date funds, targeted maturity funds and age-based funds.
Falling under the umbrella of asset allocation funds, the lifecycle fund is probably familiar to investment enthusiasts through its cousin, the lifestyle fund or target risk fund, which bases portfolios on a pre-set risk schedule. Individuals who use these types of funds typically must shift from one lifestyle fund to another several times as they get older and as their risk tolerance and other factors change. In contrast, life cycle funds enable investors to pick a plan that is designed to modify itself so that it will serve their needs over a longer period.
For example, let’s say you’re 22 years old and hope to begin receiving benefit payments at the age of 70. When you invest in a 2055 life cycle fund, you entrust the fund manager to do all of the heavy investment lifting for you during that entire 48-year career. Among their responsibilities, these fund managers are in charge of when and how to allocate and balance your asset mix until retirement. In theory, a life cycle fund gives investors the same benefits of the lifestyle fund minus difficult timing decisions. Additionally, investors don’t have to make the move to a new lifestyle fund as they age.
One of the most important aspects of a life cycle fund is its glide path. A target date fund’s glide path establishes the evolution of the fund’s allocation among different asset classes as time goes on. The glide path sets a riskier, higher-return allocation early in the life of the fund and progressively dampens its risk exposure and expected returns as the fund matures and investors age.
| REIT Usage in Life Cycle Fund Products |
| Fund Family |
REIT Allocation |
| AllianceBernstein Retirement Strategies |
10% |
| JPMorgan Smart Retirement Funds |
4%–6% |
| Principal LifeTime Funds |
3.3%–5.6% |
| Russell LifePoints Strategy Funds |
3%–7% |
| State Farm LifePath Legacy Funds |
2.8%–6.2% |
Role Playing
The potential brand confusion from the different names and flavors of life cycle and lifestyle funds doesn’t appear to have quelled the appetites of defined contribution plan administrators for them. According to a survey conducted in 2006 by PIMCO, one of the biggest fixed income investment management companies in the world, two-thirds of retirement plan consultants think that target date funds will soon be the option of choice for defined contribution plans.
Additionally, a 2007 study by human resources consulting firm Hewitt Associates found that 57 percent of retirement plan sponsors already offer life cycle funds and an additional 39 percent planned to add them to their lineup. That stands in stark contrast to the situation as recently as just 10 years ago. The Profit Sharing Council of America (PSCA), a national association of 401(k) plan sponsors and participants, reported that only 12 percent of plans offered asset allocation products in 1996.
Other data from the Employee Benefits Research Institute (EBRI) show that investment instruments such as money market accounts and guaranteed investment contracts are playing a smaller role in defined contribution plans, falling from 21 percent of all 401(k) plan assets in 2005 to 15 percent in 2006. At the same time, so-called balanced funds, a category of highly diversified portfolios that includes life cycle and target date funds, have climbed from 8 percent to 13 percent of all 401(k) assets during that time.
EBRI’s research also indicates that younger consumers just entering the defined contribution plan market have gravitated toward life cycle and lifestyle funds. In 2006, for example, the average 401(k) plan participant between the ages of 20 and 29 had an asset allocation of nearly 20 percent in balanced funds. Those in their 60s, however, had devoted only a little more than 12 percent to balanced funds, with a much larger skew toward money market funds and annuities.
Industry analysts have attributed much of the recent clamor for life cycle and lifestyle funds to recent legislative changes.
The Pension Protection Act of 2006 had broad-reaching implications for defined contribution plans, as it included provisions designed to encourage employers to provide automatic enrollment retirement plans. The bill instituted a safe harbor for retirement plan fiduciaries investing in a qualified deferred investment alternative (QDIA) in these default retirement plans.
Previously, plan providers had shied away from implementing automatic enrollment plans for fear of being held liable for default participants’ investment losses. The new Department of Labor guidelines on the legislation push plans toward using life cycle and target date funds by making them part of the safe harbor and requiring that any QDIA must be diversified so as to minimize the risk of large losses.
Kicking the Tires
While this form of all-in-one investing may sound great to those who prefer to take a backseat on investment decisions, the limited research that is available on life cycle funds suggests that these relative newcomers could still be struggling to perfect their craft.
The dearth of research on life cycle funds has prompted retirement benefits consultant Turnstone Advisory Group LLC to conduct two in-depth studies of the offerings. The first report published in 2006, “Popping the Hood,” focused on the “Big Six” target date providers—Barclays Global Investors, Fidelity Investments, Principal Global Investors, T. Rowe Price, the Vanguard Group and Wells Fargo—and contained pointed recommendations for life cycle fund managers.
 Source: PIMCO’s 2007 Defined Contribution Consulting Support and Trends Survey of 32 investment consultants and managed-account-focused firms. Participating firms include 8 of the top 10 investments consulting firms in the U.S.
Most of these companies’ funds contained “unimaginative asset allocations,” according to Joseph C. Nagengast, president and founder of Turnstone. This included underweighting real estate securities—a big mistake, he says.
A year later, Turnstone’s researchers found a different story as they compiled data for their more extensive update, “Popping the Hood II,” which is available at Plan Sponsor magazine’s Web site, and looked at a total of 175 funds run by almost 30 fund families. Although the funds still “relied too heavily on domestic stocks for return generation,” Nagengast says, the funds as a whole had made progress in improving their diversification into other asset classes, including real estate.
According to an ad hoc survey of 24 firms offering life cycle and lifestyle funds conducted by Plan Sponsor magazine, “14, or 58 percent, currently included a dedicated allocation to real estate.” Companies incorporating real estate exposure within their life cycle funds include: AIM Investments, AllianceBernstein, American Century, GuideStone Funds, ING Clarion, John Hancock, JP Morgan, Principal, Russell Investment Group, J&W Seligman & Co. and State Farm.
Ruth Falck is a senior investment consultant for consulting firm Watson Wyatt Worldwide who advises retirement plan sponsors, including major corporations, on how to build successful life cycle funds. She says she encourages her clients to include a real estate allocation of no less than 5 percent in their target date funds. She also says she has seen a clear upswing in the use and popularity of real estate.
“The advantage of adding REITs or real estate to one of these funds is pretty obvious—they’re a big diversifier,” Falck observes. “We think having a REIT fund inside an asset allocation fund makes sense. Typically committing 5 percent to asset class makes that allocation meaningful.”
Nagengast and Falck both speculate that performance-chasing could account for some of REITs’ newfound popularity among life cycle fund managers, as REITs had significantly outperformed the market for seven consecutive years prior to 2007. However, like Falck, Nagengast is more convinced that the fundamental characteristics of real estate are what make REITs more attractive.
“The increased popularity may be due to real estate’s favorable returns compared to domestic stocks and bonds, as well as the asset class’s low correlation to both, historically. This provides an excellent diversification tool for a total portfolio,” Nagengast says. “We think real estate offers good diversification benefits and should be considered as part of a well diversified, global portfolio.”
In a recent interview with Portfolio, noted investment analyst and researcher Roger Ibbotson lauded REITs’ diversification features as well. Ibbotson suggested that a well-rounded portfolio carry up to as much as 20 percent of its assets in REITs.
“You put a strong portfolio together by including things that behave differently, and REITs behave differently than either stocks or bonds. A portfolio isn’t diversified efficiently if you just buy different types of stocks or bonds, many of which tend to move together,” Ibbotson says. “Our conclusion is if you generally have REIT holdings along with stocks and bonds—as opposed to a portfolio of just stocks and bonds—you’ll do better.”
Source: Profit Sharing/401(k) Council of America.
Let Your Liabilities Do the Driving
As Turnstone found, PIMCO Executive Vice President Seth Ruthen says he has witnessed an increase in life cycle funds’ use of REITs and other real assets, which has substantial benefits. Ruthen, who just published a paper entitled “Creating the Next-Generation (Life Cycle Fund) Glidepaths for Defined Contribution Plans,” likes REITs for more than just the diversification potential, though.
“REITs offer important return and diversification potential and are important in stand-alone target date funds. Additionally, given that most participants’ other taxable wealth is in the form of stocks and bonds—assets that don’t typically do well when inflation rises—having more inflation-sensitive assets within their target date funds is a very important diversifier,” he says.
Commenting on Ruthen’s points, Kurt Walten, NAREIT’s vice president of investment affairs and investor education, says, “Whether their focus is on diversification, inflation-protection or other benefits, the buzz among investment experts in the defined contribution arena is on how life cycle funds can benefit from REIT and real estate exposure.”
Stacy Schaus, a senior vice president at PIMCO who was recently nominated for 401(k)Wire’s 2007 Senior Leader award, argues that life cycle fund managers should implement a liability-driven investment (LDI) strategy, which she says is prominent within the defined benefit plans, such as pensions. Under an LDI strategy, defined benefit plans try to avoid sudden funding shortfalls from poor asset performance.
“This is accomplished by structuring the defined benefit assets to minimize the risk that assets will be insufficient to meet the future liabilities or pension payouts of the plan” she says. “At PIMCO, we believe this same concept can be applied within defined contribution plans. Plan sponsors should consider the liability as an individual’s need to fund a lifetime retirement income. Given the objective of these assets as providing retirement income, we believe managing as tightly to that need and minimizing the risk of not meeting the objective is critical.”
Schaus contends that defined contribution plan administrators need to look at a consumer’s need in terms of real income, subject to inflation. Consequently, she shares Nagengast’s concerns about the asset allocations of life cycle funds. She laments the lack of real assets, such as REITs and commodities, in some target date funds.
“We’ve seen that life cycle funds stick close together in terms of the glide paths, with a growing allocation to equity across all timeframes, across all vintages. We believe they may fail to look at the probability of shortfall given the current asset allocation structure within the products,” Schaus says.
“Like Nobel Prize winning economists, including Harry Markowitz, pension plans view real estate as a fundamental asset class that should be included in all investment portfolios,” Walten says. “REITs provide defined contribution plans a simple way of accessing real estate. It’s encouraging to see the dramatic increase of REITs in these plans—particularly within asset allocation products such as life cycle funds.”
Allen Kenney is Portfolio’s staff writer.
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