Doing the Homework on Lifecycle Funds

By Jessica Marquez

Mar. 27, 2007

Lifecycle funds are all the rage in the 401(k) industry. These products, also known as target-date funds, address the lament of 401(k) plan sponsors who worry that their employees don’t know how to invest for retirement, according to fund providers. These funds will automatically do the work for employees by reallocating their investments so that they have enough money saved for retirement, they say.

    A target-date fund for 2040, for instance, is aimed at employees who plan to retire that year. The fund’s asset allocation moves from aggressive to more conservative to help investors reach their goal. And employees don’t have to do anything but initially invest in the fund.

    Now employees won’t even have to do that. Under the Pension Protection Act passed in August, Congress gave employers the ability to automatically enroll employees in lifecycle funds in their 401(k) plans.

    But not all lifecycle funds are alike, advisors warn. And employers should be wary about using the lifecycle funds their 401(k) plan administrators offer without doing their own research.

    “Vendors probably love these funds because they can capture a lot of assets that usually go to outside fund companies,” says Don Stone, president of Plan Sponsor Advisors, a Chicago-based retirement plan consultant.

    Employers need to do a great deal of research to get beyond the marketing hype, warns Keith Hocter, co-founder of Bellwether Consulting, a Montclair, New Jersey-based investment consultant.

    “The marketing machine is pushing so hard on these products that plan sponsors really need to step back and think about whether they really have the best solution in hand,” he says.

Cost and performance
    On a basic level, employers should have an understanding of what kinds of investments the funds include. Many of them are investing not only in domestic equities but also in real estate and international equity. Employers should understand why the manager uses each of these asset classes, says Mark Ruloff, director of asset allocation at Watson Wyatt Worldwide.

    And just as they would with any product, employers need to examine cost and performance before adding lifecycle funds to their 401(k) plans. But the structure of these products, on top of the fact that they haven’t been around for long, can make this difficult, experts say.

    Lifecycle funds are made up of a group of underlying funds, so plan sponsors need to dig into the expenses of each one, says Joe Nagengast, president of Turnstone Advisory Group, a Marina del Rey, California-based investment consulting company that recently completed a study of lifecycle funds.

    In the past, many of these funds had an overlying fee, but most have gotten rid of that, he says.

    “If companies see ‘zero’ for expenses, that might just mean there is no overlying fee,” Nagengast says. “But there will still be expenses associated with the underlying funds.” Expenses for the underlying funds generally hover around 80 basis points, he says.

    Conversely, just because a lifecycle fund has an overlying fee doesn’t mean it should be taken out of the running, as long as the performance and process are good, Ruloff says.

    Evaluating the performance of these funds, however, can be particularly tricky since many of them don’t yet have three-year track records, advisors say. And historical performance of the funds within the target date does not indicate how they will perform in the future, Ruloff says. Companies and their consultants need to establish predictive modeling to get a sense of how the funds will perform in the future, he says.

    Given the nature of lifecycle funds, there are no clear benchmarks that plan sponsors can compare them against, Stone says.

    “The benchmarks that are out there are very broad and don’t necessarily pick up all the asset classes represented in a particular lifecycle fund,” he says.

    Experts advise employers to create their own customized benchmarks based on a mix of indexes.

    “If a fund has 60 percent in equities, a company creates a benchmark that is 60 percent based on the Standard & Poor’s 500 Index,” Hocter says.

    Many lifecycle fund managers will create their own benchmarks that employers can use, says Pam Hess, director of retirement research at Hewitt Associates.

    Whether employers create their own customized benchmarks or use ones provided by their fund managers, they need to make sure the benchmarks are updated at least annually, if not quarterly, to adjust to whatever allocation the fund has, says Amy Heyel, a consultant with Segal Advisors.

    “As the allocation of the fund changes, we change the benchmark to reflect that,” she says.

    Most important, employers need to have a plan for what they will do if one or more of the funds making up the lifecycle fund underperforms, Hocter warns.

    Since these funds are still so new, this hasn’t been an issue. But it’s inevitable that sooner or later an employer will find itself with a lifecycle fund that is underperforming, Hocter says.

    “Plan sponsors need to have clear terms in their agreements with their providers to address this,” he says. “They need to have performance standards and say that if they aren’t met, the plan sponsor can replace those funds.”

Assessing allocations
    While lifecycle funds are often explained to investors as funds that simply go from investing aggressively to investing more conservatively as the employee approaches retirement, they are actually more complex than that, experts say.

    First, each lifecycle fund moves from aggressive to more conservative at a different pace, and employers need to make sure they understand how the funds make that progression, Nagengast says.

    Some lifecycle funds don’t take market conditions into account and simply reallocate according to the date of the employee’s retirement. However, many do consider market conditions, and as fiduciaries, plan sponsors need to understand which changes in market conditions prompt changes in the fund. Some funds, for example, might have a portion invested in real estate investments, and that portion remains relatively static. However, other managers may increase or decrease the real estate holdings depending on how the markets are doing.

    Plan sponsors need to make sure that the fund managers have the expertise and processes in place to make these kinds of decisions, Hegel says.

    “I would want to know if the company has a separate asset-allocation group of quantitative experts that are developing the ideas behind the asset allocation,” she says.

    Employers should also check that their lifecycle fund managers are changing the allocation toward retirement annually, rather than every five years, Ruloff says.

    “You don’t want to be selling large blocks of equities and moving into bonds once every five years because you might be timing the market wrong,” he says, adding that it’s better for managers to employ dollar-cost averaging to avoid selling equities at their lowest.

    Another area where lifecycle funds vary widely is how they invest after they pass their target retirement date.

    Some funds are more heavily weighted in equity after retirement than others, and plan sponsors need to be comfortable with their choice either way, Stone says.

    It’s in the best interest of employers to offer lifecycle funds that retirees want to stay in for a while, Hess says.

    The more retirees who stay in a 401(k) plan means the plan has more assets and lower costs, she says. The more a plan has in assets, the lower the fund expenses are generally.

Other options
    An increasing number of large plan sponsors are creating their own lifecycle funds by establishing collective trusts. This means they pick existing funds or create their own managed pools of money to create a lifecycle fund, experts say.

    Twenty-five percent of Hewitt’s clients do this either with lifecycle funds or lifestyle funds, which reallocate based on the investor’s risk tolerance, Hess says.

    Doing this can allow employers to get low-cost and high-performing funds, experts say. But only large employers with at least $20 million in their plans can take advantage of this option because they are the only ones that can qualify for the discounts, she says.

    Even if it’s more expensive, it can be worth it for employers to try to create their own lifecycle funds from various mutual fund choices, rather than what their administrator provides, Hess says.

    “Usually plan sponsors don’t get options unless they ask,” she says.

    Ultimately, employers need to remember that although lifecycle funds sound like simple investments, they aren’t.

    “These are very simple to the investor,” Hocter says. “But as a result, they entail very complex fiduciary duties.”

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