What Are Life-Cycle Funds and How Are They Structured?
(2 of 5)
What Are Life-Cycle Funds and How Are They Structured?
A life-cycle fund is really a fund "basket" that holds other mutual funds rather than individual investments. These underlying mutual funds, in total, own many hundreds of individual stocks, bonds, and cash investments.
Read some important disclosures that investors should know before investing in mutual funds.
Things To Know
- The proportions of investments making up a life-cycle fund become more conservative as you draw near your target date, such as retirement.
- There is always some element of risk, even once you are retired.
How they work
The relative proportions of domestic and international stock, bond, and cash-equivalent funds making up a given life-cycle fund vary over the years, becoming a more conservative mix as the life-cycle fund approaches its target date. Employees choose a target date that coincides with their expected retirement.
The underlying rationale is that the greater the number of years you have until retirement, the more willing and able you should be to tolerate risk (the possible decrease of investment value) in your account, in order to pursue potential higher rates of return. For a given risk level and time horizon, there is a mix of stock, bond and cash-equivalent funds that seeks to provide the highest expected potential return.
As you get closer to your retirement (the target date), the life-cycle fund’s allocation to its riskier component mutual funds will get smaller while the allocation to the more conservative funds will increase.
Typical allocations
Individual life-cycle funds vary widely, but the general gist is that a higher equity allocation is maintained when the target date is many years away. Then, during retirement, investment in domestic equity funds and international equity funds slowly decreases over the years, with bond funds and short-term funds making up an increasing percentage of the portfolio.
Then, during retirement, investment in domestic equity funds and international equity funds slowly decreases over the years, with bond funds and short-term funds making up an increasing percentage of the portfolio.
Some funds are actively managed, some are passively managed
Some life-cycle funds are baskets of actively managed mutual funds, while others are passively managed. "Active management" means that the fund managers choose component funds and individual investments after careful research aimed at picking what they believe will be winners. This research effort, of course, comes at a cost. With the "passive management" approach, fund managers do not try to pick winners; they believe this is simply not possible over the long haul or that the cost of the necessary research outweighs any possible advantage. Instead, passively managed life-cycle funds hold underlying index funds—funds that simply invest in a broad swath of the various sectors of the stock market, i.e., large companies, smaller companies, international companies, etc.
Be realistic about risk
Whatever life-cycle fund you might choose to invest in, you should be realistic about risk. Some level of investment risk is necessary if you wish to achieve returns sufficient to meet your retirement income goals. (This applies to any other investment as well.) All investments—not just stocks—are subject to risk. An investment in a life-cycle fund is not guaranteed at any time, and you could experience a loss of principal before, at, or after, the target date. Bonds and bond funds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Moreover, you must understand that while life-cycle funds provide diversification to minimize risk, diversification does not eliminate risk or ensure a profit. All types of investments are subject to loss in an unfavorable market.
