Securing the next generation of life cycle funds

Target date life cycle funds, one of the most successful investment innovations of the past generation, have come under intense scrutiny — from Congress, regulators and the media. The most serious charge is that many such funds exposed investors right on the cusp of retirement — specifically, owners of funds intended for people retiring in 2010 — to excessive equity risk just as the worst market crash since the 1930s was about to hit. Many 2010 life cycle funds dropped 25% to 30% or even more last year. For those investors who actually needed to draw income from these shrinking portfolios, the impact was severe. Does this mean the whole life cycle concept is somehow defective? Absolutely not. The core concept of life cycle investing remains sound and solid. It makes sense for young investors to take greater risks for higher potential returns and then hedge those risks as retirement nears. For many young life cycle investors, the recent market slump is actually a great opportunity to acquire long-term equity holdings on the cheap. Even the 2010 life cycle fund story isn't over yet. Many 2010 funds have rebounded sharply as the markets have rallied since March's lows. What's more, even such near-term life cycle funds are not meant to be drawn down in full on their target date; they are designed with an asset allocation meant to last many years past retirement. With all that said, though, it is perfectly legitimate to judge a risk-dampening strategy on how it performs at the margin, under stress. And by that standard, too many life cycle funds did fall short last year — some badly so. What should be done? We think that financial providers, policymakers and plan sponsors should find ways to lower the volatility of life cycle offerings near retirement and enhance their ability to provide lifelong income reliably. Here are four steps that could create a more robust model for the next generation of life cycle funds. Scrap the fund-of-funds model. The first, and simplest, would be to scrap the traditional fund-of-funds model by which most life cycle funds are created today. Under this model, life cycle fund managers have no control over the underlying funds' specific securities selection. That remains the prerogative of other managers. A simple solution is to give the life cycle manager control of securities selection in all the underlying funds used to create the life cycle portfolio — and with it a more granular feel for risk and return. Limit the total equity allocation in the “mature” phase of qualified defaults. Long periods of market gains can spur an unhealthy race to increase equity allocations in life cycle funds to goose performance and win mandates. Regulators and providers should therefore consider a ceiling for pure equity allocations in the “mature” phase of life cycle glide paths — such as the 10 years prior to a target retirement date and beyond. A cap of 50% — perhaps even lower — for such funds seems prudent, especially for life cycle funds used as the “defaults” in workplace savings plans. It is true that market forces are leading some life cycle providers to scale back their equity allocations already. But as the trauma of last year recedes and markets rise, unbounded competition — that is, with no cap or ceiling — could well lead to a replay of the equity ramp-up in life cycle funds we have recently seen. That is why a cap should be considered. And we think that the next generation of life cycle funds should be buttressed even more. Integrate absolute-return strategies. One way to do that would be to integrate the newly emerging category of absolute-return funds into life cycle portfolios. Such strategies — which can employ hedging and short selling to seek positive returns even in down markets — have long been a central element in wealth preservation strategies for high-net-worth and institutional investors. Since they have the potential of gains even amid severe securities market slumps, absolute strategies offer real diversification from relative-return funds, which almost inevitably suffer severely when all securities markets slump in unison. Directing a quarter, a third or more of a qualified-default life cycle portfolio into absolute-return strategies at the “mature” phase of its roll-down — that is, post age 55 — might be a prudent way to curb volatility at a time of investors' maximum vulnerability. Offer an annuity option to curb risk further. One last step in a “belt-and-suspenders” approach to buttressing life cycle investing would be to offer a clearly disclosed annuity option to life cycle investors — again, in the mature, post-55 stage of a life cycle roll-down. By opting to commit a quarter, a third or more of their assets to purchase a fixed annuity, mature life cycle investors could further diminish the risk that any possible replay of last year would severely damage their retirement income prospects. In considering guaranteed-income options as an element of future workplace savings plan default offerings, regulators would be well-advised to define a core annuity offering as a template. The goal would be to provide a simple, understandable, scalable model — and also to curb potentially irrational competition among insurance providers, who have repeatedly been tempted to make offers that they later fail to honor. These changes would go far toward making the next generation of life cycle offerings a more robust, more reliable source of retirement income for future generations — even through severe financial storms. But while we can — and will — adopt as many elements of these reforms as current law permits, we think that Congress and the Department of Labor could help a great deal as they did with the Pension Protection Act three years ago. Explicit endorsement of prudent changes through law and regulation makes a powerful impact. We think that the evolution of life cycle investing could benefit from fresh incentives and legal protections for employers who do the right thing — and move to adopt the ideas that we have suggested. Jeffrey Knight is the head of global asset allocation at Putnam Investments in Boston; Jeffrey Carney is head of global marketing and products.