News Analysis
BusinessWeek.com
February 24, 2006
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Smart Steps for Young Investors

By Marc Hogan

Jump-Start a Lifetime of Saving

For those just launching their working lives, target-date lifecycle funds are as easy as they sensible

Young people have plenty of excuses for not saving. They face mountains of debt, settle for shabby workplace benefits, and endure a high cost of living (see BW, 02/06/06, "Up Against It at 25").

One way to get started saving is a lifecycle fund, which helps simplify investing for the long term. Rather than fretting over that long list of unfamiliar fund names and indexes, investing newbies can estimate their retirement date and pick a lifecycle fund that matches. "It's one-stop shopping," says Don Cassidy, senior analyst with fund-tracker Lipper.

Over time, target-date lifecycle funds automatically shift their underlying holdings from stocks to bonds, becoming more conservative as investors age. Sure, well-heeled investors can hire financial advisers to do this, but that's probably not an option for someone just starting out. Ideally, lifecycle funds let novice investors maintain a diversified portfolio that's right for their time horizon -- without heavy lifting (see BW, 07/26/04, "Funds That Adjust As The Years Go By").

WASH AND WEAR.   Young people actually tend to be too cautious when it comes to investing. Workers in their 20's allocate less of their 401(k) balances to stocks than thirtysomethings do, according to a Hewitt Associates (HEW ) survey. Target-date funds avoid such misguided prudence, which can result from sticking with an ill-fitting default investment like a stable-value fund.

Lifecycle funds not only let shareholders drive hands-free, they also eliminate the need for regular tune-ups. Investors of all ages usually forget to adjust their portfolios anyway. From 2000 to 2004, only 40% of participants in 401(k) plans made a single change to their accounts, according to Hewitt. Financial advisers recommend rebalancing at least once a year, a task lifecycle funds handle without requiring any effort from investors.

And these autopilot investments are catching on. Assets in lifecycle funds with target dates nearly doubled in 2005, rising to $70.1 billion from $43.8 billion at the end of 2004, according to Financial Research Corp. More than one in five 401(k) participants in their 20's hold some kind of lifecycle fund, according to Hewitt.

IN THE MIX.  Vanguard, Fidelity, and T. Rowe Price top some analysts' lists of the top lifecycle fund providers. However, 401(k) plans usually have limited choices. It's important to have confidence in the fund family because nearly all lifecycle products are "funds of funds" investing in other mutual funds run under the same roof.

Each provider constructs its lifecycle funds differently. The Vanguard Target Retirement 2045 Fund (VTIVX ) holds just four index funds, while the Fidelity Freedom 2040 Fund (FFFFX ) uses 22 actively managed funds. The T. Rowe Price Retirement 2045 Fund (TRRKX ) invests in a mix of one index and nine active funds. "Investors need to be comfortable with the way the funds are assembled and managed," says Philip Edwards, managing director of Standard & Poor's Investor Services.

SOME CHOICE INVOLVED.  Lifecycle funds also differ when it comes to cost. Vanguard's offering has the lowest expenses, but Fidelity and T. Rowe Price (TROW ) are competitive after fee waivers, Edwards says. Some companies layer an additional management fee for lifecycle funds on top of the costs of their underlying holdings, but these three providers do not.

Asset allocations vary, too. Vanguard's 2045 fund kicks off with 90% in stocks, while T. Rowe's version is close behind with 87% in equities. By comparison, the Fidelity Freedom 2040 Fund starts with 70% in equities. Someone with a family history of longevity may prefer a more aggressive fund, but investors should also be sure they're comfortable with the potential risks involved.

Lifecycle funds are most appropriate for people who won't want to sweat those details. The key point to remember is that lifecycle funds are intended as an all-in-one portfolio that can be held until retirement. "You could argue that lifecycle funds are the ideal investment for 401(k) investors throughout your lifecycle, given their broad diversification," says Steve Utkus, a principal with the Vanguard Center for Retirement Research.

BUY 'EM, HOLD 'EM.  For investors just starting out, lifecycle funds should usually be their only investment. Adding other investments makes sense later, as they grow savvy. Some financial advisers suggest rounding out the portfolio with alternative investments, such as real estate, which typically aren't available in lifecycle funds. An exception is Barclays Global Investors, which recently added Real Estate Investment Trusts (REITs) and Treasury Inflation Protection Securities (TIPS) to its LifePath lineup.

A potential pitfall is unloading the fund after a period of low returns. Lifecycle funds are supposed to be a long-term investment, and investors should plan to buy and hold. "The trick is, don't mess with it," says Frank McKinley, a New Jersey-based financial consultant.

Another thing to consider is these one-size-fits-all funds may not coincide with your risk tolerance. What's more, you could also miss the chance for greater returns in other investments, because it's unlikely a single fund company excels in all the asset classes that go into a lifecycle portfolio.

THE TIME IS NOW.  To avoid confusion, investors should be aware that not everything labeled as a lifecycle fund has a target date. Some lifecycle funds are "risk-based" and don't change their asset allocation at all. Instead, they're tailored for an investor's risk tolerance, ranging from conservative to aggressive. Most 401(k) plans provide only one type of lifecycle fund, either target-date or risk-based.

Young investors should look for a target-date lifecycle fund, so that it can grow and adjust as they age. They only have to remember to get started.