Academic journal article Financial Services Review

Life Cycle Funds: Lack of Disclosure and Lack of Return

Academic journal article Financial Services Review

Life Cycle Funds: Lack of Disclosure and Lack of Return

Article excerpt


Life Cycle funds have been a Qualified Default Investment Option for automatic enrollment for 401(k) retirement plans since 2006. Close examination of these funds and existing benchmarks reveals little transparency or uniformity in allocation, methodology, and timing. Already $340 billion, and growing, these funds' characteristics can have a significant impact on individuals' long-term investment decisions. While many studies of Life Cycle investing use simulation, our contribution is to construct simple benchmarks for empirical analysis of Life Cycle fund performance. Our analysis shows that the funds largely underperform dynamic and static benchmarks across target dates on an absolute and risk-adjusted basis. © 2011 Academy of Financial Services. All rights reserved.

JEL classification: G23; G11

Keywords: Mutual funds; Fund performance; Target-date funds; Life Cycle funds; Retirement investments

(ProQuest: ... denotes formula omitted.)

1. Introduction

Investment has flowed steadily into Life Cycle funds, with net cash inflows of $56 billion in 2007; $41 billion in 2008; $43 billion in 2009; and $44 billion in 2010. Life Cycle fund (also called Target Date fund) investments overall increased 33%, to almost $340 billion, from 2009 to 2010. Of this, $245 billion was invested through defined contribution plans and $65 billion through IRAs. Further, one third of participants in 401(k) plans had some investment in Life Cycle funds as of the end of 2009. Already a popular option in retirement accounts because of their perceived simplicity, Life Cycle funds were designated as one of only three Qualified Default Investment Options for 401(k) plans by the U.S. Government in 2006. This designation is likely to further increase the number of plans offering Life Cycle funds from the 77% who did in 2009.1

Unfortunately, these funds have disclosure problems with respect to allocation, methodology, and timing.2 This absence of transparency is even more of a concern since 401(k) participants in their 20s held 23.5% of their asset allocation in target date funds, compared with 7.6% of their asset allocation for participants in their 60s.3 Investors in the Life Cycle option of 401(k) plans not only tend to be younger, but also to have smaller balances, and in general have less knowledge about the financial markets when compared with 401(k) investors overall, as documented by Mitchell, Mottola, Utkus, and Yamaguchi (2009). Given the relative youth and inexperience of the investor base, our analysis and results have long-term implications for a large number of individual investors. The purpose of this paper is to provide a basis for understanding the asset allocations, fee structure, and risk-adjusted performance of these funds.

Another contribution of this paper is to examine some of the benchmarks for Life Cycle funds and assess whether or not the funds have provided investors risk-adjusted return over their history. While many authors have studied simulations of asset allocations over investor life cycles (e.g., Ervin et al., 2009; Kyrychenko, 2008; Meyaard and Templeton, 2002; Pfau, 2010; Schleef and Eisinger, 2007), few have analyzed the indices currently used to benchmark Life Cycle funds. We parse these indices, and construct dynamic and static indices to analyze the performance of Life Cycle funds and common benchmarks.

Life Cycle funds (also commonly called Target Date funds) are a subcategory of all-in-one mutual funds that provide diversification and active asset allocation over time. Life Cycle funds are intended to become more conservative systematically as the investor's target retirement date approaches. Life Cycle funds set target retirement dates such as 2010, 2015, 2020, . . . , 2045, 2050, 2055. When a fund is first established, with a long term until the target retirement date, the fund manager invests heavily in equities. With the passage of time, the fund manager gradually shifts the investment mix towards more conservative debt securities. …

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