Risky Business
Selecting a lifestyle, or target-risk, fund for a plan sponsor might seem like a simple task for an adviser. All lifestyle funds, after all, are based on the same basic proposition: Make the investment decision easy for participants by matching a pre-mixed pool with an equity-to-bond ratio based on the participant’s individual risk tolerance. Typically that means offering a minimum of four fund mixes: aggressive, moderately aggressive, moderately conservative, and conservative.
Yet, the decision for a plan sponsor and its adviser is anything but routine. To begin with, more than 1,000 lifestyle funds currently are listed on Morningstar. The composition, pricing, and investment strategy of those funds can differ widely, and so can the style, tactics, and commitment of the manager of the funds.
Although these risk-based funds seemingly have faded in popularity as their target-date counterparts have flourished, advisers continue to recommend them, frequently instead of the target-date funds. However, advisers need to make a whole array of decisions before selecting a good lifestyle package for a client sponsor and—like target-date funds—the deciding factor(s) should transcend just asking the recordkeeper which suite of funds is available.
More recently, these funds have really taken off, because of an increase in automatic enrollment and provisions in the Pension Protection Act of 2006 that positioned them as qualified default alternative investments (QDIAs), under the balanced fund definition. That allowed sponsors to establish a lifestyle fund as the default investment for participants, while taking advantage of the QDIA’s fiduciary protections.
The first task probably should be to check out the demographics of the sponsor’s participant base and find a fund manager who can serve that demographic. If the participants are highly educated, well-heeled, and sophisticated investors who want to be involved in building their own portfolios, lifestyle funds might not really make sense. These funds are aimed at participants who lack the interest, ability, or investment knowledge to make choices for themselves. The average age of the participant base is another key factor. A company with mostly young employees might want more aggressive lifestyle funds than a sponsor whose workers are in their 40s or 50s, understanding that not all funds with the same name have the same composition. (In fact, in order to qualify under the QDIA regulations, plan sponsors must consider plan demographics in selecting a default option). Average asset size also can be important, because many providers establish their pricing structure based on plan assets or number of participants.
Advisers say it is critical to look carefully at a manager and his or her track record before making a choice. That vetting of fund managers should include studying their investment styles and philosophies to be certain they are in tune with the needs of the sponsor.
It is equally important, perhaps even more so, to study the underlying investments that constitute the fund. Some managers stick with their companies’ own proprietary funds. Others offer an open architecture. Some lifestyle fund managers are reluctant to rebalance their portfolios. Others will do so regularly. Some are managed actively; some are indexed. Some funds carry just mutual funds and bonds; others might have alternatives like global investments and REITs.
Modeling
One trend aimed at bypassing the outside fund manager entirely is for advisers to create their own lifestyle funds, generally from funds already in the plan lineup and, therefore, vetted in the investment policy statement (IPS) and by the plan’s investment committee.
“We’ve had very good success in creating our own asset allocation portfolios,” says David Snetro, Senior Vice President with the broker/dealer Retirement Plan Services. Under such a scenario, the adviser can eliminate and add funds whenever he sees the need. Such flexibility is not possible when an outside manager controls the portfolio.
Some sponsors, of course, might ask their advisers if a lifestyle fund even makes sense for their plans.
Yes, almost always yes, says Patrick Cunningham, Managing Director with Manning & Napier: “I can’t think of one circumstance where you would be doing a plan a disservice by having a lifestyle or lifecycle fund to add to a diversified menu.”
The fruits of investing in lifestyle (and lifecycle) funds can be found in a study conducted by Burgess & Associates for John Hancock USA. That survey said that 10-year annualized returns for participants invested in a single lifestyle fund averaged 7.2%, while, for non-lifestyle investing participants, it was 5.3%.
Lifestyle funds do carry an added cost, as much as 50 basis points or more. While pricing always has to be a concern, it should not necessarily be the primary determinant, says Christine Soscia, Vice President and plan consultant with Las Vegas-based 401k Administrators. “We don’t always take the least expensive provider,” she says. “We take the provider that has the whole package.” That package, she explains, should include factors like the strength of underlying investments and customer service. “I find a provider with the best fit for the sponsor,’ she says, with cost being just one consideration.
Despite their popularity, advisers and analysts say the newer target-date, or lifecycle, funds might soon edge lifestyle funds out of the market. Target-date funds are designed to last a participant throughout their accumulation phase (some go even beyond that), automatically becoming more conservative as participants pass certain ages and move closer to retirement. Lifestyle funds do not change in that way, so participants must switch to more conservative funds as they grow older. Therefore, that can make target-date vehicles even more effective options for the disinterested participant.
The demise of lifestyle funds will accelerate, says Neil Netoskie, the head of BBVA Compass’ retirement solutions group, if the IRS one day determines that all defaults should go into target-date funds. “I think the old lifestyle funds are going to disappear,” he predicts.
Illustration by Frank Stockton