Planning for long-term financial goals like retirement can often seem overwhelming. Lifecycle funds, also sometimes called target-date funds, offer a solution that's designed to evolve with you over time and take some of the complexity out of deciding what investment approach is right for you.
Let’s talk about what lifecycle funds are, why they’re so useful, and how you can even create your own DIY version using exchange traded funds (ETFs).
What Are Lifecycle Funds?
A lifecycle fund is a professionally managed, all-in-one investment solution tailored to meet financial milestones, specifically retirement. It’s rooted in the theory of life cycle financial planning, which takes a multi-stage approach to investing based on age and life stage.1 A lifecycle fund adjusts asset allocation over time to align with the investor’s stage in life.
When you are decades away from retirement, a lifecycle fund allocates a higher percentage of your investment to equities to maximize the opportunity for long-term growth. Stocks typically offer the potential for higher returns, along with higher risk.2 As you move through the investment life cycle toward the target date of retirement, the fund gradually allocates more money to bonds, which can offer more stability but lower returns.3
How a Lifecycle Fund Works
If today you invested in a lifecycle fund with a target date of 2055, for example, it’s safe to assume that you should be around 30 years from retirement. That’s a long-term horizon so a typical asset allocation is 80% equities, to maximize growth, with a 20% allocation to fixed income for diversification. By the time you reach retirement age in 2055, the allocation should have shifted to around 30% stocks and 70% bonds.
As a retiree, you’ll still need some equity for growth, but you’ll want the majority of your assets in stable fixed income instruments that should help insulate your portfolio from market volatility and potentially provide interest income. The beauty of the lifecycle fund is in the convenience, as you’re saved from the annual headache of manually rebalancing your investment allocation.
Why Are Lifecycle Funds Useful?
Lifecycle funds simplify the process of investing. They offer a few key benefits:
Ease of Use—You don’t need to spend time researching asset allocation. With a lifecycle fund, professional managers make the decision for you.
Automatic Rebalancing—Lifecycle funds automatically adjust your investments over time, offering age-appropriate risk. This saves you from the stress of manually shifting your asset allocation as you age or as your financial circumstances evolve.
Diversification—These funds typically comprise multiple underlying funds, offering exposure to a wide range of securities across industries, geographies, and asset classes.
Cost Effectiveness—Most lifecycle funds, while professionally managed, are not actively managed. Passively managed funds mirror the composition and performance of a particular index and consequently charge lower fees, particularly compared to paying a financial advisor for asset allocation advice.
Risk Management—By gradually reducing risk as you age, lifecycle funds seek to preserve capital for the time in your life when you’ll need it most.
For ordinary investors, these funds can serve as a convenient, all-in-one portfolio solution. But some investors may want to be more hands-on, or perhaps lifecycle funds don’t align with all of your financial priorities. If so, you can use exchange traded funds (ETFs) to build a lifecycle-like portfolio.
A DIY Solution to Build Your Own Lifecycle Fund
Using ETFs, you can build a customized lifecycle fund with the same type of glide path as a prepackaged mutual fund.
Step 1: Define your target date
First, decide when you want to retire or at what point you’ll want the money you’re saving. If it’s 30 years in the future, that target date will inform how you build and adjust your portfolio. You should invest more aggressively now and become more conservative over time.
Step 2: Develop an asset allocation strategy
To approximate a lifecycle fund, you’ll need two primary asset classes, stocks for growth and bonds for stability.
Stocks will make up most of your portfolio in the early years. Look for ETFs that invest broadly, like index funds.
Since bonds help lower the overall risk of your portfolio and add stability while minimizing volatility, you’ll want to invest in one of the many total US bond market indexes available.
When you begin investing, you might allocate as much as 80% of your portfolio to stocks and adjust these weights over time.
Step 3: Incorporate diversification
To enhance your portfolio’s diversification, consider adding funds focusing on small caps, global investments, or specific strategies to complement the broad-market funds that form the base of your strategy.
Believe it or not, you can also diversify the bond portion of your portfolio with something like an international fixed income ETF.
Step 4: Establish a glide path
Your glide path defines how your asset allocation changes over time. It could look something like this:
- 25+ Years to Target Date: 90% Stocks, 10% Bonds
- 15-25 Yeas to Target Date: 80% Stocks, 20% Bonds
- 10-15 Years to Target Date: 70% Stocks, 30% Bonds
- 5-10 Years to Target Date: 50% Stocks, 50% Bonds
- <5 Years to Target Date: 30% Stocks, 70% Bonds
Depending on your personal risk tolerance, return objectives, and financial circumstances, you may prefer to be more or less aggressive with these allocations. No matter how much risk you take on or don’t, however, the point is to adjust it over time, weighting more of the portfolio to fixed income as you get closer to your target date.
Step 5: Monitor and rebalance
A DIY lifecycle portfolio does take a little more work. Rebalancing ensures that your portfolio stays on track with your financial objectives. If stocks perform well, the weighting may increase, and you may need to sell stocks and buy bonds to restore the desired asset allocation.
We believe you should aim to rebalance at least once or twice annually to maintain your target allocations. Instead of choosing a calendar date, you might define a % deviation from the preferred allocation to trigger a rebalance. Some brokerage platforms offer automated rebalancing tools that allow you to establish glide path rules that will save you time and effort.
Finally, be mindful that selling assets can trigger capital gains taxes. When possible, rebalance within tax-advantage accounts like IRAs or 401(k)s to minimize tax liability.
The Takeaway
Lifecycle funds are a convenient, hands-off way to manage investments and achieve long-term goals. They offer automatic diversification and adjustments over time. They’re complete for investors who want simple solutions and don’t want a lot of involvement.
For investors who want more control, a DIY version of the lifecycle fund built using ETFs can achieve similar results. By creating your own glide path, maintaining diversification, and rebalancing periodically, you can create a robust portfolio tailored to your needs.
Whatever the course you choose, always remember that the key to long-term success as an investor is starting early, staying disciplined, and sticking to your long-term plan.
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