On target

Mutual funds that gear 401(k) participants’ asset allocations to their retirement dates are catching on. Target-date funds may eclipse other life-cycle funds.

When Gary Amelio took over as executive director of the Thrift Savings Plan, the federal workers’ retirement system that is the country’s largest defined contribution plan, with $178 billion in assets, he was well aware that employees tend to get confused about how to invest. “People simply don’t have the time or inclination to choose their own investments,” Amelio says. “Getting a professionally managed investment option on the roster was at the top of my agenda.”

At Amelio’s urging, the plan’s trustees voted last August to give TSP’s 3.5 million participants access to target-date retirement funds -- portfolios managed with a participant’s retirement date in mind. A money manager -- Barclays Global Investors, in TSP’s case -- rebalances the asset allocation as the worker ages.

TSP’s L (for life-cycle) funds were an instant hit. In just five months 270,000 federal employees, or almost 8 percent of all TSP participants, moved $9.5 billion into L funds. “We’ve met our five-year goals in seven months,” says Amelio. “We’ve surpassed our wildest expectations.”

Life-cycle funds, which come in two varieties, target-risk and target-date, have grown phenomenally. Their assets hit $226 billion at the end of last year, up from $69 billion at the end of 2002. About 90 percent of the assets are in 401(k) and other retirement accounts; 10 percent are in individual investor accounts.

Ross Frankenfield, the analyst who tracks life-cycle funds at Boston-based consulting firm Financial Research Corp., says the heady growth reflects a secular shift in retirement savings. “We’re in the second stage of the development of defined contribution plans,” he contends. “In the first, employers were shifting from defined benefit to defined contribution plans and offering an overwhelming array of choices. Now people are moving back to professionally managed investments.”

The more established life-cycle offering, target-risk funds (commonly known as lifestyle funds), accounts for the bulk of these assets: $156 billion, or nearly 70 percent. But target-date funds, with $70 billion in assets, threaten to eclipse target-risk funds.

Though they sound similar, the two types of life-cycle funds are quite different. Investors select a target-risk fund based on their appetite for risk. It is then up to them to switch funds as their risk-tolerance changes, typically from a stock-heavy fund when they are young to a more balanced one as they age. About 60 fund families offer target-risk funds.

But the explosive growth in life-cycle funds comes in the newer category of target-date funds (which some fund families, adding to the labeling confusion, also market simply as life-cycle funds). Investors stipulate their likely retirement date and leave asset allocation and investment decisions up to a money manager. For TSP’s target-date participants, BGI shifts asset allocations every quarter. Target-date portfolios are typically funds of mutual funds; 21 fund families offer them -- eight having entered the market in the past year.

Fidelity Investments, which has been selling target-date funds since 1996, dominates this part of the business. It had a 41.6 percent share of net new target-date fund flows in 2005. The No. 2 player, Vanguard Group, which began offering the product in October 2003, has a 21.6 percent share and T. Rowe Price, which entered the market in September 2002, claims an 18 percent share. The remaining 18.8 percent is divided among 18 fund companies.

Back in 2003, facing much less competition, Fidelity boasted a 77 percent market share of target-date fund assets. At year-end it claimed 57 percent.

“In 2002, Fidelity was the only large player offering target-date funds,” says Scott Gilmour, the senior vice president in the firm’s employer services division who oversees product development. “We could hardly expect to keep our market share of something so successful.”

Last month, recognizing a growing need, Morningstar introduced a new rating category for life-cycle funds so that investors could better compare rival products. “We create new categories when enough funds are sufficiently different from the general pool to treat them separately,” explains Morningstar analyst Russel Kinnel. The firm presents three benchmarks for target-date funds built around retirement-date ranges: 2000 to 2014, 2015 to 2029 and 2030 and beyond.

Dow Jones & Co. has begun marketing life-cycle fund indexes, says John Prestbo, editor of the Dow Jones indexes. State Street Global Advisors is using them for its life-cycle funds, and New Yorkbased Arrivato Advisors, a start-up fund family, has just licensed the indexes for its life-cycle offerings. “There’s a great need for transparency -- to understand the current holdings and trajectory of a life-cycle fund and to be able to understand the fees,” notes Eric Rubin, the president of Arrivato.

Fees for target-risk and target-date funds range from 10 to 150 basis points. Fund families create a variety of share classes, offering certain shares to institutional investors making large purchases, others to intermediaries who sell to plan sponsors, and still others to individual investors.

What are the relative merits of target-risk and target-date funds? The purveyors of the former contend that the notion of an individual’s acceptable risk -- ignored, they say, by target-date funds -- is paramount in making investing decisions. “Two 40-year-old investors can have very different risk tolerances. It just doesn’t make sense to invest off a birth certificate,” says Robert Boyda, senior vice president of John Hancock Investment Management Services, which has approximately $17 billion of target-risk fund assets -- but as yet sells no target-date funds. “We’re continuing to review the demands of the marketplace,” Boyda notes.

Defenders of target-date funds counter that simplicity has its virtues. “These are the simplest choice, and they’re the most likely option to get the avoiders to participate,” says Gerard Mullane, the head of institutional sales at Vanguard, which offers both life-cycle products. But “we are agnostic on the relative merits of target-risk and target-date,” he adds.

All life-cycle funds aim to mitigate longevity risk: the threat of outliving one’s savings. AllianceBernstein concluded in a 62-page research report published last October that the asset allocations of most life-cycle funds underemphasize equity, particularly toward the end of a participant’s working years. “If defined contribution plans are the future of most people’s retirement, their structure is critical,” points out Seth Masters, AllianceBernstein’s chief investment officer. Masters oversaw the research report, which was written by Thomas Fontaine. Many participants, Masters says, fail to grasp the importance of generating the highest returns when their contributions are also at their highest level, or just after they retire, when their portfolio is typically at its maximum value.

Masters points out that a plan participant who contributes $5,000 a year over a 40-year working life might retire with a nest egg of either $844,000 or $1,037,000, depending solely on the timing of the years with the highest returns.

Both Fidelity and Vanguard made the allocations for their target-date funds more aggressive last month. Fidelity is shifting its fund allocations for people who are already retired. Those portfolios have been split 50-50 between equities and fixed income when a participant retires and then rolled down to 20 percent equities and 80 percent fixed income as he or she approaches actuarial life expectancy. The roll-down used to take five to ten years; now it tends to be ten to 15.

Vanguard increased its equity allocations for all target-date funds, as well as adding emerging markets and international equities to the mix.

IBM Corp., which froze its defined benefit plan in January, strongly advocates life-cycle funds. “Personally, I have all my retirement savings in our [target-risk] funds,” says Jay Vivian, managing director of retirement funds at IBM, which has more than $26 billion in 401(k) accounts.

IBM’s 250,000 employees keep 15 percent of their 401(k)s in mostly target-risk funds, which the company has provided since 1993. Although it began offering target-date funds in January 2005, the response has been negligible, says Vivian, because the older product is better-known to employees.

No asset manager, large or small, catering to the defined contribution market dare overlook life-cycle funds. The International City/County Management Association Retirement Corp. serves only state and municipal defined contribution plans and has a modest $12 billion in assets. But Washington-based ICMA’s target-risk funds have been on the market for six years and claim $3.4 billion in assets. And a year ago the firm introduced target-date funds: They already total $145 million, and ICMA reports that they are attracting 20 percent of all new contributions.