Nest Eggs in Multiple Baskets

In the late 1990s, academic researchers began noticing an interesting but disturbing side effect of the roaring bull market: 401(k) investors consolidating their investment positions. Specifically, instead of diversifying their portfolios, many 401(k) participants were buying big stakes in their employers' stocks. Even at companies with strong investment education programs, plan participants seemed

In the late 1990s, academic researchers began noticing an interesting but disturbing side effect of the roaring bull market: 401(k) investors consolidating their investment positions.

Specifically, instead of diversifying their portfolios, many 401(k) participants were buying big stakes in their employers' stocks. Even at companies with strong investment education programs, plan participants seemed content to ignore the basic tenets of diversification. Many employees simply put equal amounts of their assets in each investment option. In a plan with five stock choices and one bond alternative, for instance, participants put most of their assets in stocks, says Shlomo Benartzi, a professor at UCLA. But at a company where there was one stock choice and several bond options, participants favored fixed income.

A Forgiving Bull

With stocks rising, many employers turned a blind eye to the haphazard approaches. But after the markets collapsed, employees howled and plan sponsors scrambled for solutions. Some companies hired online services or financial advisors to help employees build sensible portfolios.

But, increasingly, employers have begun offering so-called life cycle funds, which include broad mixes of stocks and bonds. By picking one life cycle choice, an investor can hold a nicely diversified portfolio.

With plan sponsors rushing to enlist, assets in the funds have climbed to $110 billion, up from $66 billion at the end of 2002, according to Financial Research Corp. Though much of the demand comes from retirement plans, life cycle funds are now attracting assets in taxable accounts as well. The leader is Fidelity Investments, with more than $40 billion in assets in the funds. Other big players include Vanguard Group, Putnam Investments and MFS Investment Management.

T. Rowe Price, which introduced several portfolios two years ago, says its funds now have $1.5 billion in assets.

“This is the most successful product launch we have had,” says Jerome Clark, portfolio manager of T. Rowe Price Retirement funds.

The life cycle funds mainly are funds of funds — portfolios that invest in several mutual funds — and they come in several flavors. The simplest are sometimes called target allocation because they hold fairly stable mixes, such as 60 percent of assets in equities and 40 percent in fixed income.

Companies typically offer a series of choices ranging from bond-heavy conservative choices to growth-oriented funds with 80 percent or more in equities. More complicated selections are known as target-date funds because they are designed for people aiming to retire on specific years. For example, Fidelity offers a range of dated funds, including Fidelity Freedom 2005, 2010, 2020 and 2040. A 50-year-old person might invest in a fund with a target date of 2020. As that year approaches, the fund gradually becomes more conservative, shifting away from equities and into fixed income.

“The investor needs to make only one decision, and the fund manager takes care of the all the rebalancing,” says Vernon Meyer, vice president of MassMutual Financial Group, which offers a line of retirement-date funds.

Advisor Unfriendly

The funds come in a variety of load and no-load share classes, but some advisors have been reluctant to try the offerings for one very good reason: life cycle portfolios are designed for do-it-yourselfers or people with small accounts.

“I prefer doing my own work to develop customized portfolios for clients,” says Richard Bregman, chief executive of MJB Asset Management, a registered investment advisor in New York.

To overcome such bias, some companies are making special efforts to reach advisors. In addition to selling no-loads, Fidelity offers an advisor class of shares that come with five different load structures. The company sells an institutional share class for fee-based advisors. In the first four months of 2004, Fidelity reports selling its Fidelity Freedom retirement-date funds to a total of 4,200 advisors. Some of the buyers have rolled retirement accounts into IRAs, putting all the cash in a Freedom fund. But a growing number of advisors are starting to use the retirement funds as core holdings that can be supplemented with a few more specialized funds or individual securities.

“Instead of worrying about picking lots of funds, some advisors would rather spend their time focusing on building overall financial plans,” says Donald Holborn, executive vice president of Fidelity's Institutional Service group.

The target-date funds typically start with hefty stock allocations for savers with longtime horizons. Vanguard's 2035 fund now has 64 percent in equities. The equity figure will gradually drop to 35 percent on the retirement date. At that point, the fund will have 50 percent of assets in bonds and 15 percent in inflation-protected securities.

After reaching their retirement dates, most of the funds shift into static allocations. Fidelity's retirement funds become static and then merge into Fidelity Freedom Income, a fund that normally has about 20 percent in equities and the rest in cash and bonds.

T. Rowe Price takes a different approach, holding a relatively big position in equities and continuing to lower the stock allocation gradually for decades after the retirement date. T. Rowe Price Retirement 2005 fund has 59 percent of assets in stocks and will lower the figure until 2035. At that point, the equity holdings will become fixed at 20 percent. The company arrived at the strategy after considering various scenarios and deciding that a sizable stock allocation is the best way to protect retirees from outliving their assets.

One-Stop Shopping
Life cycle funds at a glance.
Fund Ticker Category One-year Return Three-year Return Five-year Return Maximum Front load
Fidelity Freedom
2010
FFFCX Moderate 9.4% 2.3% 3.9% 0.0%
Putnam Asset
Allocation: Growth A
PAEAX Moderate 19.4 1.8 1.9 5.25
T. Rowe Price
Retirement 2040
TRRDX Large Blend 20.6 NA NA 0.0
Vanguard
LifeStrategy Moderate Growth
VSMGX Moderate 13.8 2.6 2.8 0.0
WM Strategic
Asset Conservative Growth A
SAGPX Moderate 17.1 1.0 5.1 5.50
Source: Morningstar. Returns through 5/31/04.

To provide diversification, some funds hold a wide range of choices. Fidelity Freedom 2040 has investments in 15 funds, including Fidelity Equity-Income, Fidelity Overseas and Fidelity Capital & Income, a high-yield bond specialist. The funds are monitored constantly and can be rebalanced every day to make sure that no holding gets outside its target allocation.

For each of its five target-allocation funds, Manulife Financial hires a mix of well-known subadvisors including Davis Funds and American Funds.

“The idea is to make sure that every fund is extremely well diversified with a good balance of growth and value stocks,” says Steven Medina, Manulife's vice president of investment management services.

Because of their convenience, the life cycle funds seem likely to continue growing. Some advisors may see that as a threat from a new competitor that could draw away clients. But the life cycle funds could present an opportunity, says Sam Campbell, an analyst with Financial Research Corp.

“Firms are talking about using these funds for their lower-dollar clients,” he says. “That would allow the representative to focus on servicing people with more to invest.

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