Lifecycle Funds Are Popular, but Not for Everyone

Thanks to the Pension Protection Act signed into law last year, companies can automatically enroll employees in 401(k) plans. That's great for people who are lax when it comes to saving for retirement. What's more, much of the nest-egg money will flow into what's known as lifestyle or target-date funds — diversified funds that are designed to reallocate your assets from aggressive to more conservative as you age.

It will be the latest boost to a category of funds that have already exploded in popularity.

Between 2003 and 2005, assets in these funds — also known as target-retirement funds — held within 401(k)s grew a whopping 141%, according to investment-research firm Cerulli Associates. Meanwhile, total 401(k) assets increased only 20%. There were only 22 target-date portfolios in 2000, according to investment-research firm Lipper, compared with 122 by year-end 2006; 49 new portfolios have been launched since the beginning of 2007 alone.

"That's definitely one of the strongest-growing investment vehicles in the industry," notes D.J. Lucey, an analyst with Cerulli. "With the PPA clarifying the suitability of lifecycle funds [for 401(k)s], I can see them growing even more substantially than they already have."

But do lifecycle funds make sense for you? True, they can be a huge improvement for folks who, left to manage their portfolios alone, end up chasing hot returns, parking their savings in money-market funds, or not saving at all, says Roy Weitz, who runs the industry watchdog FundAlarm.com. "But there's a big area between the people who do nothing, and the people who'd do something stupid," he says. "Those are the investors who might be better off on their own."

Here's why you may want to think twice before throwing your retirement stash into a target-date fund.

In other words, this could be the only fund you'll ever buy. "It's perfect for investors going into a 401(k) plan who are not educated about investments and don't want to be," says Ellen Rinaldi, principal of the Investment Counseling and Research group at Vanguard. Yet, Rinaldi concedes, target-retirement funds aren't for everybody. "These funds are designed for a broad class of people," she says. "But not everyone fits in."

Harold Evensky, a fee-only certified financial planner in Coral Gables, Fla., has one fundamental problem with these funds: By grouping together investors based on their age alone, these funds overlook many of the factors that help determine one's appropriate asset allocation. "On average, [target-date funds] are a good answer," he says. "But people aren't average."

An employee who is near retirement and has a sizable portfolio outside of his 401(k), for example, might be able to afford a more aggressive or conservative 401(k) strategy — depending on his risk tolerance — than an employee whose retirement eggs are all in the 401(k) basket. Likewise, an investor whose spouse plans to work for 10 additional years could retain a higher equity stake longer than spouses who will retire together.

One way to get around this is to switch your target date, fund companies say. Go for a later-dated one if you need a more aggressive approach; choose an earlier date if you are more risk-averse. But by doing so, you're also submitting your portfolio to a reallocation strategy designed for people retiring either before or after you. If you choose a 2030 fund but plan to retire in 2020, for example, you might find yourself with a larger share of equities than you should have in your first 10 years of retirement.

"I've seen middling funds used in target-date funds," says Greg Carlson, an analyst with investment research firm Morningstar. One is the Fidelity Europe (FIEUX) fund, he says. Following a management change last year, the fund's 2006 returns trailed its category by 8.4 percentage points, according to Morningstar. Year to date, its one-year return ranks it worse than 98% of its competitors. While individual investors could decide to seek a better European stock fund elsewhere, with the Freedom funds you have no choice: The fund is in all target-date portfolios, notably among the top five in 2050 (FFFHX) and 2045 (FFFGX). (Granted, past performance is no indication of future results and, as Fidelity Freedom Funds co-portfolio manager Jonathan Shelon points out, the idea of retirement investing is taking a long-term view. "Our job is not to chase performance," he says.)