Deciding on lifecycle and target-date funds

Lifecycle funds and Target-date funds form an important part of the market for retirement products. This article explains the difference between the two retirement funds and discusses the important features that investors should look for in target-date funds.

We have, in this column, discussed about the relevance of lifecycle fund and target-date fund as part of an investor's retirement portfolio. The question is: What features should these products offer to make them optimal retirement solution to investors?

This article explains the difference between traditional lifecycle funds and target-date funds. It then discusses the typical features of such funds and also suggests what asset management firms can offer to make the funds more attractive.

Lifecycle funds and target-date funds carry stocks and bonds in their portfolio. They primarily differ in their asset allocation policy. Lifecycle funds typically offer three variants based on the investors' risk tolerance levels — aggressive, moderate and conservative. The aggressive variant has higher allocation to equity while the conservative variant has higher allocation to bonds.

Suppose an investor aged 25 invests in the aggressive variant of the lifecycle fund, she will continue to have high exposure to equity till retirement date. It is generally true that risk tolerance level of a mass-affluent investor declines with age: this is not true for the rich, for risk tolerance is driven more by the level of wealth. But lifecycle funds are not sensitive to changes in an individual's risk tolerance level.

Target-date funds have an investment horizon. Such type of funds adopt an asset allocation policy that continually reduces equity exposure as the fund reaches the target retirement date. Target-date funds are sensitive to changes in risk tolerance level of individuals. The question is: What features should such funds offer to help investors achieve their retirement objectives?

Glide path

The process that a target-date fund adopts to reduce its equity exposure based on the investors' age and risk tolerance level is called the glide-path. It is the glide-path and the individual asset exposure that differentiates target-date funds.

The following features would be optimal for a retirement fund: One, the fund should have a closed-end structure. This spares the portfolio manager from holding cash to meet redemption requirements. Open-end funds will suffer from cash drag. This refers to the lower returns that an open-end fund may earn because returns earned on cash held for redemptions are typically lower than returns the fund can earn if it invests the cash in stocks or bonds.

Two, retirement funds should have optimal glide-path; for it is the optimal asset allocation policy that will drive portfolio returns. A target-date fund should typically change its asset allocation policy based on investors' age and risk tolerance. A fund that changes its asset allocation less frequently is likely to expose the investor to high risk.

Three, lifecycle and target-date funds are typically fund-of-funds. Such a structure suffers from high costs due to additional layer of fees. Retirement funds that directly invest in stocks and bonds are preferable, as the saving on fees could be substantial, given the long-investment horizon.

Asset management firms should pay close attention to glide-paths when offering target-date funds. Such funds should also offer a judicious mix of passive equity exposure and maturity-matched bonds. Passive exposure to equity will mitigate active risk on equity while maturity-matched bonds will remove market risk on bonds. Such a fund can form part of an investor's core retirement portfolio. Retirement funds can also offer complete solution by changing the investment composition at the target date to generate retirement income.

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