IMAGINE A MUTUAL FUND THAT GROWS with you, automatically adjusting the allocation of stocks and bonds to reduce risk and volatility as you grow older. When you’re young and have plenty of time to ride out the ups and down of the market, the fund is heavily into stocks. As you approach retirement and a time when a sudden bear market could be devastating, the fund gradually shifts toward bonds.
Now, say hello to target-retirement funds. Also called life-cycle funds, they put your retirement saving on autopilot. Just select a fund with a name that contains a year close to when you plan to retire. Add money regularly. Relax. These relatively new inventions — which already hold about $60 billion — become more conservative as you grow older, so they match your need for more financial stability as you approach retirement.
Of course, a great idea is only as good as its execution. And as with all types of funds, life-cycle funds have stars and stinkers. Fortunately, you can eliminate many funds based on the expenses they charge.
Because target-retirement funds often invest in other funds, they can have two layers of fees — those of the under-lying funds plus an additional expense on top. Be sure you know all the relevant fees. Some target-retirement funds even charge sales loads. Unless you’re getting financial advice, you shouldn’t pay such a fee. Ignore funds whose expense ratios approach or top 2 percent. In fact, aim to pay less than 1 percent.
Performance, of course, is a chief reason for choosing life-cycle funds. Because most life-cycle funds have only been around a few years, it’s impossible to make performance comparisons for the most recent five- and 10-year periods.
Pick your mix. Another component of performance is the recipe used to mix the funds — especially the proportions of stocks and bonds. The more bonds you use, the less volatile the anticipated performance, but also the lower probable long-term return. Some of the leading fund families that offer life-cycle funds provide distinctly different cookbooks. For example, T. Rowe Price Retirement 2015 invests 71 percent of assets in stocks, while American Century 2015 has just 54 percent in stocks (and Vanguard 2015 has even less — 47 percent).
Jerome Clark, manager of the T. Rowe Price retirement funds, notes that over time, the risk from having a high percentage of your money in stocks or stock funds diminishes. “In investing for retirement, your biggest risk is outliving your money,” he says.
If you like a certain fund family but think its life-cycle fund is weak on stocks, there’s an easy solution. Just pretend you’re younger than you are. When investing in the Fidelity or American Century funds, simply add 10 years to your retirement date (15 years if you’re using the Vanguard funds). This sleight of hand lets you overcome the funds’ conservative bent and gets you more stocks, fewer bonds. Once you’re retired, the American Century and T. Rowe Price income funds both provide optimal allocations. In theory, you could put all your retirement money in a single life-cycle fund. But few investors, if any, would do so. So keep in mind that you need to properly balance all your holdings.
To illustrate, here are some details on life-cycle funds from four firms. Aside from the stock-versus-bond ratios, these families differ in other ways:
American Century. When it comes to the ingredients, this Kansas City–based firm rules. American Century puts a small portion of assets of most target funds in its inflation-adjusted bond fund, its real estate fund, and its emerging-markets fund, all of which provide diversity. The total expense ratios range from 0.83 percent to 0.96 percent. One drawback: American Century’s foreign funds have generally been subpar. But the firm has hired a new lead foreign manager.
Fidelity. Although Fidelity’s target funds do a good job, they could do better. A couple of the firm’s best stock funds, most notably Contrafund, are missing from the mix. The expense ratios range from 0.58 percent to 0.79 percent. Over the past five years, Freedom 2010, 2020, 2030, and 2040 have returned an annualized 4 percent, 3 percent, 3 percent, and 2 percent, respectively. For three years, the annualized returns for the four funds have been 9 percent, 12 percent, 13 percent, and 14 percent.
T. Rowe Price. Laudably, T. Rowe Price target funds invest about 5 percent more in foreign stock funds than the other three firms do. Expense ratios range from 0.64 percent to 0.80 percent. Too new to have five-year records, the funds have done well in the bull market of the past three years. Retirement 2010 is up an annualized 12 percent, 2020 has returned 14 percent, and 2030 and 2040 have both gained 15 percent.
Vanguard. The conservatism of these target funds dampens their potential. Still, they’re good choices because the money is invested entirely in Vanguard’s own top-notch, low-cost index funds. Expense ratios are remarkably low, ranging from 0.20 percent to 0.21 percent. Because they were launched in 2003, Vanguard’s life-cycle funds lack three-year records. But those low expenses are bound to pay off over time.
Kevin McCormally is the editorial director of Kiplinger’s Personal Finance magazine. For more information, visit kiplinger.com.
