You may think you have your clients' asset allocation completely covered--and you probably do, in the accounts that are under your advisement. But your clients probably have assets you don't manage in their 401(k)s, where they are increasingly likely to invest in a life-cycle fund. This new genre of mutual funds is flourishing, especially in 401(k) accounts. You may even want to recommend them to clients with smaller accounts. Essentially, life-cycle funds allow investors to choose the portfolio that best correlates with their risk tolerance or future retirement date. Life-cycle funds defined by risk tolerance are often referred to as "lifestyle funds," whereas life-cycle funds with a specified retirement date are typically called "target retirement date funds." This study focuses on target retirement date funds (target-date funds). All the data in this study came from Morningstar Principia.

The asset allocation among U.S. equities, non-U.S. equities, bonds, cash and other (which generally consists of preferred stock and/or convertible bonds) within a target fund becomes more conservative based on a timetable devised for the specific fund until the "target date," which should approximately coincide with the investor's year of retirement. The prevailing approach is to shift from a stock-heavy portfolio to a bond-heavy portfolio over time as the fund nears its target date. For example, an investor who is 25 years old in 2006 and is planning to retire in 45 years would look for a fund with a target date of about 2050. The target date is generally stated in the name of the fund. Once the target date is reached, these funds progress at varying speeds toward a mostly bond portfolio.

BOOMER BULGE

Life-cycle funds are relatively new. First introduced in 1990, they totaled 167 by the end of 2005. (This total considers only "distinct" share classes.) Most of that growth has occurred in the last two years: Nearly 60% of the 167 funds were introduced after Jan. 1, 2003. Of these 167 life-cycle funds, 115 were target-date funds.

Just as you probably have a preferred allocation, so do product manufacturers, so it's no surprise that the composition of various target-date fund portfolios differs significantly, even for those with the same target date. Among the 115 funds in our study, the average number of portfolio holdings was 58, but the median number was 10. In the vast majority of cases, these are "funds of funds"; the underlying holdings are either index funds or actively managed funds. However, some target funds are assembled like a mutual fund, containing dozens to hundreds of individual securities.

Three different target-date funds--Vanguard Retirement 2025, Fidelity Freedom 2015 and Wells Fargo Adv Outlook 2030 A--illustrate these differences. As of year-end 2005, the Vanguard fund had five holdings, all of which were index funds: Vanguard Total Stock Market Index (44% of the portfolio), Vanguard Total Bond Market Index (42%), Vanguard European Stock Index (8%), Vanguard Pacific Stock Index (4%) and Vanguard Total Stock Market VIPERs (2%). The Fidelity offering had 23 actively managed Fidelity funds, while the Wells Fargo choice had 938 individual securities, with U.S. stocks representing 59% of the portfolio, non-U.S. stocks 19% and bonds 22%. But the Wells Fargo portfolio is the exception to the rule; among the 115 target-date funds, 81 had fewer than 15 holdings, which is indicative of the fund-of-funds approach.

The distribution of target-date funds and net assets is illustrated in "Where the Money Goes," below. At year-end 2005, more than $65 billion was invested in mutual funds with a stated target date. The most popular target dates (based on the number of funds and amount of assets) were 2010, 2020, 2030 and 2040. As of Dec. 31, 2005, there were 18 distinct funds with a stated target date of 2010 holding a total of $13.9 billion in net assets. The largest target-date-fund asset base--over $18 billion--is invested in 2020 funds, which corresponds to people born in the mid 1950s. Not surprisingly, this represents the midpoint of the baby boom era--the 18-year period from 1946 to 1964.

 

Studying the performance of life-cycle funds is premature because so many of them have less than a three-year history. So in this study, we specifically examined the portfolio composition of target-date life-cycle funds. We singled out the 83 target-date funds that had at least one year of operation.

As shown in "The Decades at a Glance," below, the asset allocation for funds with the same target date can vary widely. For example, among the 15 funds with a target date of 2010, Scudder Target 2010 had a 74.5% allocation to bonds at the end of 2005, while T. Rowe Price Retirement 2010 had 22.8% of its portfolio in bonds. These two funds represent the extremes.

 

On average, the 15 funds targeted for the year 2010 had about 10% allocated to cash, 36% to U.S. equities, 9% to non-U.S. equities and 45% to bonds. Among the 13 funds with a target date of 2040, the average current allocation to U.S. equities was about 66%, though one fund (MassMutual Select Destination Retirement 2040 L) had 79.3% committed to U.S. equities as of year-end 2005, while another (Russell LifePoints 2040 Strategy D) had just over 46% in U.S. stocks.

At the bottom of "The Decades at a Glance" is the average asset allocation data for a group of 181 non-target-date funds that may represent a comparison group for target-date funds. These funds have the Dow Jones Moderate Portfolio as their "best-fit" index, which is also the most common best-fit index among target-date funds. The asset allocations (cash, U.S. stock, non-U.S. stock, bonds, other) of the non-target-date funds are most closely aligned with target-date funds that mature in 2010, 2015 or 2020.

This simply suggests that target-date funds "maturing" in the next 15 years are not that different from the funds Morningstar categorizes as Moderate Allocation or Conservative Allocation. Among the 181 comparison funds, 78 were listed as Moderate Allocation and 52 were Conservative Allocation.

The breakdown of the specific target-date funds in this study is shown in "The Players" on page 98. In general, target-date funds offered by T. Rowe Price tend to have the highest percentage of their portfolios invested in equities (U.S. and non-U.S. combined).

The asset allocation strategies of the prominent target fund categories (2010, 2020, 2030, 2040) are illustrated in "Color Scheme" at right. As of year-end 2005, the 15 funds with a target date of 2010 had an average allocation of 10% in cash, 35% in U.S. stock, 9% in non-U.S. stock and 46% in bonds. Target-date funds geared to mature in 2040 tended to have about 5% in cash, 65% in U.S. stocks, 20% in non-U.S. stocks and about 10% in bonds. As previously noted, the portfolio composition of the non-target-date comparison funds (the pink bars) is generally most similar to 2010 funds and 2020 funds.

CHEAPER BY THE DECADE

The average net expense ratio of the 83 target-date funds in this study, as listed in the prospectus, was 0.98% (median 0.94%). The average net expense ratio of the 181 comparison funds was 1.29% (median 1.19%). Thus, we found evidence that target-date funds are less expensive than non-target funds. The expense ratio of target-date funds represents the weighted expense ratios of the underlying funds.

Finally, it's interesting that the allocations to large-cap U.S. equities, mid-cap U.S. equities and small-cap U.S. equities were almost identical regardless of the target date of the fund. All of the life-cycle funds in our study tended to invest about 74% of the U.S. equity portion of the portfolio in large-cap stocks, roughly 19% in mid caps and about 7% in small caps. The cap-based allocation of the U.S. equity portion of the portfolio among the 181 non-target-date funds was essentially the same. We had anticipated that target-date funds with maturity dates further in the future would commit a higher percentage to mid- and small-cap U.S. equities. The highest allocation we found to small caps was in the NestEgg 2040 Service Fund, with nearly 19% of the U.S. equity portion invested in small caps. We also found several funds with nearly 29% in mid caps. Nevertheless, on average, target-date funds tended to have a relatively light exposure to mid- and small-caps within the U.S. equities portion of the portfolio. Given the superior return of smaller companies over time, we find this odd for funds that are specifically built for the long haul. While the notion of a target fund is reasonable, we think that target funds that mature 20 to 30 years in the future ought to include a higher percentage of small- and mid-cap equities.

Craig L. Israelsen, PhD, teaches family finance at Brigham Young University. His email is craig_israelsen@byu.edu. Katie Walker is an undergraduate at Brigham Young University.

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