A Cross-Examination of Life-Cycle Funds

Life-Cycle Funds (LCFs), otherwise known as Target-Date Funds, were originally conceptualised in the early 90s as a response to new ideas in retail investing. Ideas such as the importance of diversification, the failures of active management, the potential of passive investing, and the power of asset allocation were bursting onto the scene following academic work and books such as A Random Walk Down Wall Street.

Successful investing didn’t require time and effort selecting specific assets, apparently. All you had to do was buy everything, sit back, crack open a tin of Foster’s and watch the money roll in. LCFs were built on this idea. Just invest in increasingly “safer” assets the closer you got to retirement (by swapping share-based funds for bond-based funds) and you were golden.

Composition

In slightly more formal terms, the idea is that your portfolio should transition to less-volatile assets as you approach retirement. More-volatile assets, like stocks, out-perform on average and over the long term. Hence, you want a high % of these assets in your portfolio in the beginning of your investment journey to capture some of this out-performance. However, as you approach retirement, you need more stability. You don’t want your portfolio to suddenly drop 20% in value 3 weeks before you need the money for retirement. Enter less-volatile assets. These assets (allegedly) provide much-needed stability to your portfolio before you liquidate and ride off into the sunset.

In reality, this idea typically manifests itself in the proportions of equity and bonds held in your portfolio:

Target-Date Funds shares vs. bonds mixture. Source: Vanguard.
Vanguard

As with most things passive, Vanguard dominates the space. They have a range of funds, all with a 0.24% ongoing charge and risk score out of 7. One simply has to input the target date (AKA retirement date) and the boys at Vanguard will take care of the rest:

Target-Date Funds shares vs. bonds %. Source: Vanguard.

What exactly is in these portfolios? A mix of Vanguard funds. Here is the composition of the 2065 fund, for example:

Vanguard Target-Date Fund 2065 composition. Source: Vanguard.
Perpetual Prudence

When it comes to investing your money, you must proceed with extreme caution. We are playing not to lose, first and foremost. Prudence is a necessity. Any substantial potential investment must be thoroughly cross-examined before being considered.

LCFs are no exception. We must take a close look at the faults of these vehicles.

First are the performance issues. Switching between funds and constantly rebalancing to match some desired allocation all incur transaction costs, which lower returns. LCFs are typically associated with higher fees than other pure-passive products, too. Vanguard’s long-dated Target Retirement Funds have ongoing changes of 0.24% compared to around 0.1% for their index funds. This is because your money has to be managed in some way. You are paying to have your performance determined by someone else (fees reduce your return). Some may enjoy this lack of control/responsibility but others (admittedly including yours truly) who are a little more on the controlling side may struggle with the lack of ability to determine the composition of their portfolio.

This distaste for relinquishing control could be justified. Bad things can happen when you give people total control of your money. This is partly caused by misaligned incentives. For example in this context, Vanguard is trying to make as much money as possible. They are incentivised to do things like encourage you to invest in higher-fee products and only invest in Vanguard products, which may not necessarily be in your best interests. Your ultimate goal is successful Lifetime Investing. It’s not Vanguard’s.

Vanguard, and other LCF providers, don’t care about you. They offer a product, not a personalised service. This means that they don’t take your personal situation into account when encouraging you to invest in one of these funds. Your risk profile is irrelevant to them. Two different investors, with two different abilities to take risk, should have two different portfolios, even if their retirement dates are the same. LCFs fail to accommodate this difference.

There is also the question of what you actually do with the funds at the maturity date. LCFs were designed with the idea of having a pot available to you at retirement in mind (to withdraw as a lump sum or to purchase an annuity). However, many are discarding this pot-centric approach in favour of a more continuous one in which retirees remain invested in the market. Some are choosing to continue holding their portfolio throughout retirement and withdrawing as and when needed, rather than the annuity-based approach of the past. LCFs were not designed for the former.

That’s the main problem with these funds, really. The rigidity means that you’re locked in to the LCF was of investing for retirement. But people change. Your approach may change. Shit happens. Less shit can happen inside of a pension portfolio, granted, but the point remains. A change in approach to retirement investing, investment philosophy, rules/taxation surrounding pensions, etc. could leave you caught with your trousers down. LCFs are not designed to be liquidated half way through their duration. It’s not going to be the end of the world, sure, but it may lead to less-than-stellar returns.