Planning For Retirement When You Know Nothing: Life-Cycle Funds

The only thing I knew about investing at age 24 was that it was important.  I could not have told you even 17 words about stocks, bonds, index funds, and real estate if you put a gun to my head and said “start talking.”  However, I was determined to have enough money to stop working when I was old.  I might not have had a clear notion of an age for retirement, but I knew I would eventually stop working.

As incompetent as that sounds, I realize now that the majority of people are in my position.  They have a job, possibly a benefits package, some debt (in my case, federally subsidized educational loans), and a desire to invest.  Most people have virtually zero financial management know-how. 

I was fortunate to stumble into something called a target-date fund, a kind of life-cycle fund, which significantly eased my entrance into the investing world.  There are a number of benefits to this account, and a few cautions, which I will outline. 

Target-Date Fund

A Target-Date Fund, also known as a “life-cycle fund” or “age-based fund” is the slow cooker of investing.  I recently made chicken soup in my slow cooker, and it was almost exactly like my Target-Date Fund (just less expensive).  I purchased my ingredients, went through some minor food preparation, threw them into the slow cooker, set the timer and temperature, and walked away.  When the timer went off, the slow cooker automatically switched to “warm.”  I checked on it, adjusted the seasonings, and had soup for later that week. 

Like the slower cooker, you place your before or after-tax dollars into a target-date fund, and walk away, because the fund automatically adjusts is asset-allocation over time from a high to low risk position based upon your age.  This makes it attractive for a number of reasons:

  1. The financial institution actively manages the fund, not the investor (a great feature, if you don’t know much, or don’t want to focus on, asset allocation).
  2. The goal is clear: retire by a certain age (most of us can imagine an age we want to retire).
  3. The financial institution uses mutual funds to provide a reasonable distribution of equity and fixed-income assets. 

Target-date funds are extremely popular, and financial institutions are actively marketing them.  But, unlike chicken soup, I do not recommend completely ignoring them until the timer goes off.  Your financial future is worth your attention.  Here is why:

Market performance:  If your retirement goal is 65, and you are diligently putting 12% into the target-date fund, and the market performs poorly when you turn 58, you may wish to move a larger portion of your portfolio into a cash or bond position, than the fund would automatically distribute.  Conversely, after retirement, your final portfolio value may not be large enough to sustain moving to a more conservative allocation mix. 

Single vehicle strategy:  Possibly the larger problem with target-date funds is that to function optimally, you must use that fund, and that fund alone.  Think about it.  The financial institution managing your target-date fund does not account for any other stock, real estate, or other assets you may own.  They manage the fund exclusively.  This means that if your fund is 80% equity and 20% fixed-income assets, and you also use 10% of your investment assets to purchase stock, this effectively increases the stock component of your overall portfolio.

The reason I like the target-date fund, is that it is an a great way to begin understanding the basics of investing for retirement.  The concept of the fund, which begins with a more aggressive allocation, and slowly moves to a more conservative allocation, helps a novice investor understand asset allocation over time. 

Bottom line:  You have to pay more attention to retirement savings than chicken soup, but for novice chefs and investors, a target-date fund is a good method to start a financial future you can savor. 

There is another type of life-cycle fund, one I now prefer.

Target-Risk Fund

A risk-based fund, like the target-date fund, is a mutual fund that provides individual investors with a well-diversified mix of equity and fixed-income assets.  However, where the target-date funds builds a mix of stocks and bonds that align to a targeted retirement age, risk-based funds align to a targeted risk level.  Some restaurants put hot pepper pictures next to entrees on their menu to indicate the level of spice and heat in a dish, with more peppers signaling a spicier item.  Target funds operate in a similar fashion: if you are conservative, and like slow and steady growth, or aggressive, and can tolerate significant fluctuation, there is a risk-based fund for you – just look at the risk tolerance level.

With target-risk funds most funds are generally

If fund risk levels were on a menu, and rated by heat level

If you decide you want a different risk level, you have the option to switch to a different risk-level fund.  The reason I like a target-risk fund, is that I can focus on aggressive growth, and do not need to be concerned with what a target-date fund “thinks” I should be concerned with. 

If you recall, one of the challenges of the target-date fund, is the single vehicle strategy.  In my case, my husband has his own moderately invested retirement accounts, and we own a rental property that is almost assuredly going to continue appreciating in value and some steady dividend-bearing stock.  Our larger strategy compliments aggressive investing.  Further, I have two target-risk funds with different financial institutions, which use different mutual funds, further dispersing risk.

Bottom line: You can use target-risk funds as part of a larger strategy, and can generally feel comfortable knowing you can switch between risk-levels as you become more competent and aware of the “heat level” your palette tolerates.

If you know very little about investing, life-cycle funds offer a terrific way to get started.  Watching the fund allocation and performance is one of the best ways to grasp the basics of investing.

Photo by Evan Dennis on Unsplash

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Investopedia has several articles on life-cycle funds, that make worthwhile reading https://www.investopedia.com/terms/l/life_cycle_funds.asp

Comments

2 responses to “Planning For Retirement When You Know Nothing: Life-Cycle Funds”

  1. Christine M. Schwarz

    I didn’t know about this nomenclature. I think we have two of these funds of the low-risk type. With my company 401 K. I went with medium risk. I made out OK, not fabulous. What do institutions typically call these funds?

    1. Dan Carlson

      If you didn’t specifically identify index funds, stocks, bonds, then you were most likely in some kind of a mutual fund which auto-distributed either by risk or by age. I have an old 401K, that asked me a series of questions, including risk level, and then did some kind of allocation across different asset types. They are very useful. But you do need to keep an eye on them.