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I am often asked about lifecycle mutual funds in general and Vanguard’s Target Retirement funds in particular.   Readers somehow have gotten the vibe that I hate these funds.  I don’t hate them, but I also don’t use them in my retirement portfolio because they don’t work for me.  This post will explain why.

Lifecycle Funds

A lifecycle fund is a balanced mutual fund, holding both stocks and bonds.  It is also a “fund of funds”, meaning its only holdings are other mutual funds.  The fund is automatically rebalanced to maintain its desired asset allocation as time goes by.  Lifecycle funds follow a specific “glide path,” generally becoming less aggressive as the years go by.  Most of the big mutual fund companies offer some type of life cycle fund and they are often offered within 401Ks.  According to Forbes, there are now more than 2000 lifecycle funds and they contain 13% of 401K dollars.

The worst lifecycle funds not only use actively managed mutual funds that are unlikely to outperform as the years go by, but also add on a fee in addition to the expense ratios of the underlying funds.  My favorite lifecycle funds, the Target Retirement funds at Vanguard and the “L Funds” in the TSP don’t do this.  Vanguard also offers the “Life Strategy” funds, which used to contain actively managed funds, but now are essentially the same as the Target Retirement funds except that they maintain the same asset allocation each year rather than becoming less aggressive as time goes on.  Lifecycle style funds are also available in many 529s, they just have a steeper glide path as the student approaches college age.

Advantages of Lifecycle Funds

Lifecycle funds, particularly those from Vanguard and the TSP, can be great investments.  They are low cost, low maintenance, and reasonably well allocated among various asset classes.  They provide instant diversification not only among asset classes, but within asset classes.  They are a great one-stop mutual fund shopping solution that you can recommend to less sophisticated investors and that can be placed in a 401K to alleviate fiduciary liability concerns.  Another important advantage of balanced funds is that they are less volatile, so investors are less likely to engage in behavioral errors such as performance chasing and selling low.  With all these advantages, why don’t I use them?

Problem # 1 – Not Available In All Accounts

I have a complex portfolio because I have three 401Ks, two Roth IRAs, an HSA, a Defined Benefit Plan, and 529s for all the kids.  No single lifecycle fund is available in all of these accounts.  What is the point of a one-stop mutual fund solution if you have to mix it with other funds?  There is none.  I could hold lifecycle funds in some accounts, but balanced funds in general and lifecycle funds with their ever-changing asset allocation in particular don’t mix well with other mutual funds in an asset allocation.  Even if you can get to an overall asset allocation you like, rebalancing involves much more complex calculations when you toss in some lifecycle funds.

Problem # 2 – The Dates Are Misleading

Albert Einstein said “Make things as simple as possible, but not simpler.”  I think lifecycle funds fall into the trap of making things simpler than they should be.  The idea of choosing an asset allocation based on just one factor, the date you plan to retire, doesn’t necessarily account for your unique ability, need, and desire to take risk.  For example, the Vanguard Target Retirement 2045 fund has an asset allocation of 90% equity.  In a big bear market, that fund may lose about 45% of its value.  Not everyone who plans to retire in 2045 can psychologically handle a 45% drop in their retirement account value without bailing out and selling low, resulting in an investment catastrophe.

To make matters worse, every fund company has a different asset allocation for any given date.  For example, Fidelity’s Freedom 2020 fund is 49% equity, Vanguard’s Target Retirement 2020 fund is 62% equity, and the TSP L 2020 Fund is 54% equity.  If you’re going to use a lifecycle fund, choose it based on the asset allocation (and change funds depending on your desired asset allocation periodically).  If you’ve got to understand asset allocation anyway, what’s the point of a date-based lifecycle fund?  The only argument its proponents can really make is, “Well, it’s better than lots of stupid asset allocations people come up with either on purpose or on accident.”  That’s true, but it doesn’t take a whole lot of sophistication to come up with your own desired asset allocation and implement it.

Problem # 3 – I Want A Different Glide Path

I’m a little bit of a control freak and like to be in control of my investments as much as possible.  A lifecycle fund changes my asset allocation automatically.  Automatic investing can be a great thing, but I prefer to have more control over my asset allocation.  For example, I have had a 75/25 asset allocation for the last decade.  It works for me in both bull and bear markets.  I may take less risk as I get older, but to me it makes a lot more sense to decrease equity allocation after a big run up in stocks, rather than just doing it automatically at 1% or so per year.  A gradual decrease is better than dumping stocks after they’ve had a bad year or two, but I don’t feel like I need to protect myself from this behavioral error by using a lifecycle fund.

Problem # 4 – I Want A Different Asset Allocation

Did I mention I’m a control freak?  I also like to tinker.  Vanguard’s Target Retirement 2020 Fund holds only 4 asset classes.  My portfolio contains 12.  Do you need 12?  Of course not.  There is little benefit at all to having more than 10, but there are lots of benefits to having more than 4.  I also buy into the idea that “tilting” a portfolio toward asset classes with higher expected returns (like small and value stocks) is likely to result in higher long-term returns.  Lifecycle funds don’t generally have small value tilts, nor do they include REIT allocations, microcap allocations, Peer 2 Peer Loan allocations etc.  If you enjoy debating the merits of short term TIPS vs intermediate term TIPS you’re not going to be happy with a lifecycle fund.  Is it possible I’d be better off with a simpler total market based portfolio?  Of course.  In fact, Mike Piper, a very sophisticated investor, has a Life Strategy fund as his only investment holding.  But I’m willing to bet my life savings that I can do better than a lifecycle fund, and so far, I’m winning that bet.

Problem # 5 – Life Cycle Providers Chase Performance

Lifecycle fund managers are just as guilty as the rest of us at chasing performance.  Just before the 2008 bear market, mutual fund companies seemed to be competing to see who could get a more aggressive asset allocation and glide path into their lifecycle funds.  Vanguard recently added international bonds to its target retirement funds.  When you buy a lifecycle fund you’re getting some active management in your asset allocation, and like all active management, you may or may not come out ahead because of it.  These funds are hardly the stable long-term allocations they market themselves as.  Fund companies are also tempted to place their new mutual funds into their lifecycle funds.  This gives the new funds “instant assets under management,” making them appear more successful than they would otherwise be.

Problem # 6 – Taxable Time Bomb

One of the biggest problems with lifecycle funds is that they are inappropriate for taxable accounts because they become increasingly tax-inefficient as the years go by.  As a general rule, if part of your portfolio is in retirement accounts and part is in a taxable account, you want to preferentially place tax-efficient asset classes (like stocks) into the taxable account, leaving tax-inefficient asset classes (like bonds and REITs) in the tax-protected retirement accounts.  If your only holding is a balanced fund, then you’re necessarily holding at least one asset class in a suboptimal location.  To make matters worse, as you get closer to retirement a lifecycle fund gets more and more tax-inefficient as the bond allocation increases.  Fixing the error becomes more expensive each year as the taxable capital gain in the fund increases.  Lifecycle funds also don’t contain municipal bonds, which high earners forced to hold bonds in taxable should probably be using.

Problem # 7 – Life Cycle Funds Are (usually) More Expensive

Many lifecycle funds add on an additional fee above and beyond the expense ratios of the underlying accounts.  Even the providers that don’t do this, like Vanguard, may charge more in other ways.  Vanguard offers cheaper “admiral” shares of most of its funds if you have at least $10K in the fund.  However, the funds held by the Target Retirement funds are NOT the cheaper admiral shares, they are the more expensive investor shares.  For example, the Vanguard Target Retirement 2020 Fund has an expense ratio of 0.16%.  I can built it myself using admiral shares for 0.10%.  Now, 6 basis points isn’t much I’ll admit, and the TSP DOES NOT charge more for its lifecycle funds, but some fund providers charge dramatically more.  Always remember that investing expenses come directly out of your investment return.

Lifecycle funds can be great investing options, especially for investors with small portfolios located entirely within a single retirement account, but they don’t work for my retirement portfolio and there’s a good chance they’re not the best option for yours either.

What do you think? Do you use a lifecycle or target retirement fund? Why or why not? Comment below!