Target Retirement Date Lifecycle Funds: Ignorance Is Never Bliss

by: Daniel Moser

In Monday's edition of the Financial Times monthly review of the funds management industry there is a discussion regarding the evolution of lifecycle funds by Anup Basu, Alistair Byrne and Michael Drew. It seems like these funds have gained substantial traction and in fact have become quite the rage in recent times. However, investors should take some time to evaluate these funds before making a long term commitment to these strategies.

Just because lifecycle funds have a target retirement year doesn’t mean you can count on them for retirement. In a 2007 Washington Post article, Martha Hamilton explores lifecycle funds and expresses concerned that “different funds have different formulas, and they can’t all be right.” She goes on to say, “a Consumer Report analysis in 2006 found a wide variation in the level of stock investment funds with a target date 2020, ranging from 50.1 percent of holdings to 86.3 percent.”

While the asset management industry might have good intentions with these products in terms of simplifying the investment process, there is inherent risk that many investors have no knowledge about.

In the Washington Post article, Zvie Bodie, professor of management at Boston University, and Joe Nagengast of Turnstone raise another important concern – “the fact that the funds can't guarantee that investors' retirements will be fully funded. The problem, they say, is that consumers may assume that the target dates mean they will be. A variety of factors, however, determine whether a retirement is fully funded by any given date, including how much an investor puts aside and how well the market performs.”

The article goes on to point out that Bodie and Nagengast do not believe the fund management business is misleading investors but rather investors in lifecycle funds are likely to view target-date funds as a surer thing than they are, which is investments in markets with all the risks that entails. According to Nagengast, “if you put 2020 on the name of the fund, I don’t care what you say after that, that’s all people are going to focus on.” Nagengast goes on to argue that when you talk to mutual fund companies, in their eyes these are just another type of mutual fund…

It’s just a mutual fund. We’re not liable for anything any more than with any other mutual fund. We’re responsible for managing according to the mandate, but we can’t guarantee results.

One final point that sticks out in the WP article is that Bodie and Nagengast argue that “there is a danger that the funds will be too heavily invested in stocks at or near the point at which investors begin withdrawing their money.” Walla! Just like that a tremendous amount of investors in these funds were clobbered just like any other long only investor heavily weighted toward equities going into the financial crisis and ensuing recession.

The FT extends this discussion a bit further in Monday's paper, discussing the next phase of evolution for lifecycle fund engineering. The current strategy of these lifecycle funds is to start out (assuming an investor with a long time horizon) heavily weighted toward equities. As the target retirement date nears, the fund automatically (we hope) shifts toward fixed income and other less volatile investments to protect the investor’s wealth. The new grandioso idea: a fund that doesn’t shift to safer investments automatically but rather looks back at the historic performance of itself and decides if its investors have accumulated wealth in excess of the target at the specified switching point. I can’t think of a better analogy than a gambling addict at the tables doubling down with borrowed money after having lost his family’s accumulated savings.

According to the FT article, this new type of strategy, if implemented, “produces superior retirement wealth compared with conventional lifecycle switching in most cases. By using the dynamic switching strategy, the risk of falling short of the investor’s target is reduced by almost 40 percent in some cases.” This quite simply, in my estimation, improperly relies upon historic data. The simple fact is that historically, there has been a business cycle in which equities, at some point, outperform other asset classes from the low points of a recession. If the retirement target date of a traditional lifecycle fund happened to be at or near the low points of a recession, any recovery in stocks would be forgone by investors in these funds because the fund would have naturally been de-risking into safer assets, likely leaving investors short of their goals–just as Bodie and Nagengast argued in 2007. BUT, these new dynamic lifecycle funds appear to be splendid investments because they, faced with recessionary lows, are dynamic enough to look back and say we didn’t perform well enough for the past 3,5,10 years…so we will just maintain an allocation to equities and wait for a recovery – in effect, never actually de-risking. One could very easily argue if this new strategy gains traction it will mean feast or famine for investors.

My take: target retirement lifecycle funds are a poor substitute for brains. In an almost insidious way the asset management industry is tricking capital into an almost permanent time horizon since it can easily be argued that investors can’t expect outperformance or even adequate performance for holding periods less than the target retirement date. Most people, lacking sufficient personal finance education, are being led to believe that they can use a “set it and forget it” strategy for these investments. Such an approach couldn’t be further from the truth. These funds masquerade poor performance and introduce a tremendous amount of risk that is misunderstood and more likely unknown by their investors.

Investors should annually (at a minimum) review their finances. This should include a review of the risks of their investment holdings including funds. The ostrich strategy of burying your head in the sand is seldom a grand idea. Even the famously long holding periods of Ben Graham and Warren Buffet were first initiated with an excellent review of the company they were investing in – and follow up reviews on some sort of recurring basis no doubt ensued. Love him or hate him, it is hard to argue against Jim Cramer when he says “buy and homework” rather than “buy and hold.” And the fact is: that rule applies to investment funds as well as individual stocks. Don’t be fooled into thinking that ignorance is bliss.

Good luck and thanks for reading.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.