From Barron's 10/17/05:

Risky Voyage

The Sins of Life-Cycle Funds
By PHIL DEMUTH

IN OUR BOOK Yes, You Can Still Retire Comfortably, Ben Stein and I concluded that the main risk facing baby boomers is what actuaries call "negative mortality." We call it "running out of money before you die." This experience is likely to be just as unpleasant as it sounds. Let's avoid it, shall we?

The conventional wisdom says we must become more conservative with our investments as we get older. The bromide is to keep the percentage of stocks in our portfolios equal to 100 minus our current age. By this logic, a 20-year-old should have a portfolio that's 80% stocks and 20% bonds; a nonagenarian, 10% stocks and 90% bonds.

The financial-services industry has encased this thinking in its "life-cycle" and "target-retirement" funds. The thinking seems to be that, by putting all our eggs into one fund, we can put our portfolios on autopilot, leaving the thorny issue of asset allocation to the pointy-headed experts while we recline in our La-Z-Boys and become millionaires.

We wouldn't bank on it.

Take, for example, the Vanguard Target Retirement 2035 Fund (ticker: VTTHX) -- designed for today's 35-year-old who wants to retire at age 65 in 2035. This recently was allocated 77% into stocks. With the passing of time, its allocation gradually will be rejiggered until it reaches that of Vanguard Target Retirement 2005 (VTOVX), for today's 65-year-olds, whose dial recently was set on 33% stocks (0% in offshore assets). A few years thereafter, it will become even more conservative, morphing into Vanguard Target Retirement Income (VTINX), with 20% in stocks and the rest in fixed income.

At Fidelity, we find the same story: The Fidelity Freedom 2035 Fund (FFTHX) recently had 82% stocks, declining to 44% in Freedom 2005 (FFFVX), and finally bottoming out at 20% in Freedom Income (FFFAX).

T. Rowe Price follows suit, although with a heftier stock exposure. Its T. Rowe Price Retirement 2035 Fund (TRRJX) goes from 89% stocks to 57% for those retiring today, ending at 43% stocks for those solidly retired.

That the equity exposure among these funds varies so widely indicates that asset allocation isn't an exact science. Should today's retirees have 33% or 43% or 57% in stocks? The answer has a significant impact. To find out what Ben and I consider the ideal, you can read our book (hint: 50%).

The larger problem embedded in all these funds is that risk tolerance doesn't decline uniformly over the typical person's lifetime. By risk tolerance, we mean the degree of risk that an investor should rationally assume, given his or her goals. "Risk" here isn't standard deviation or fluctuation in portfolio value, but rather what statisticians call "negative semi-variance," or what we term the risk of "losing money." How much you can afford to lose is a function of how much time you have to make up any losses, and whether you might be forced to sell assets at distressed prices before they recover.

This risk doesn't decline steadily during a lifetime, as conventional thinking suggests. Rather, it follows a 'U" shaped curve. The most dangerous time for investors is during the period immediately before and after retirement. A steep loss here could force you to sell assets on the cheap (AKA negative dollar-cost averaging) simply to provide for everyday living expenses. Fall into a ditch here and you might never climb out. Earlier in life, you have the luxury of time to let compound interest do its magic. Later, your portfolio has to carry you through less and less time. Even if it takes a hit, you can burn through principal to fuel your remaining years.

Balanced against this, remember that today's freshly minted retiree is necessarily a long-term investor. An undead white male of 65 has an average life expectancy of nearly 78 years. And half of these guys will live longer, and some will live much longer: The top one percentile has a life expectancy of 105 years. Unless you plan to die young, you must prepare for the long haul. Yet, only T. Rowe Price gives retirees a significant (43% versus 20% for Vanguard and Fidelity) equity exposure. Only the rich can afford a low-risk, low-equity allocation. Without a larger exposure to stocks, portfolios are unlikely to meet long-term retirees' needs.

When the mutual-fund companies look to populate these life cycle funds-of-funds, unsurprisingly, they find the choicest offerings already under their own roofs. Vanguard indexes nearly everything with its own index funds, Fidelity looks mostly to a smorgasbord of its actively managed funds, and T. Rowe Price uses both in-house strategies.

None invests to any meaningful extent in stocks from emerging markets, although these economies are likely to be the 21st century's major growth engines. And none of these funds take the small-cap and value tilt that has proven to boost returns for long-term investors. On the bond side, weightings of inflation-protected securities are too low (only Vanguard has a 25% allocation to TIPS), considering that inflation is historically retirees' Public Enemy No. 1.

And it's not as if these funds are providing a bushel of income to compensate for their lack of growth prospects. According to Morningstar, Fidelity Freedom Income had a trailing 12-month yield of 2.19% (yes, that's $21,900 a year of income from a million-buck nest egg -- and then you pay taxes). No wonder: nearly half of the fund is in cash.

T. Rowe Price and Vanguard do a bit better, recently offering 2.30% and 3.52% yields, respectively. Still, these aren't the kind of yields that have silver-haired septuagenarians and their wives piloting sloops around Nantucket, as we see in the ads (unless they're planning to scuttle the vessels to collect insurance).

Considering that the masses' general investment knowledge could be writ large on the head of a pin, the effort to greatly simplify retirement investing is excruciatingly important. Still, mutual-fund companies' execution of this strategy leaves considerable room for improvement. We hope that life-cycle funds will be reincarnated into higher forms before their shareholders are.

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PHIL DEMUTH is co-author, with Ben Stein, of Yes, You Can Still Retire Comfortably, published by New Beginnings Press.

Follow-Up Letter to the Editors 11/7/05

Stocks Are Safe, Just Wait

To the Editor:

Hats off to Phil DeMuth ("The Sins of Life-Cycle Funds," Oct. 17), especially, for spotlighting the woeful lack of equities in many such funds. Time changes the relative risk of asset classes. The traditional notions of risk and reward are based on the volatility of various asset classes over holding periods of one year or less. This can be misleading for individuals who are investing for 5, 10 or even 20 years. It ignores the cost of low returns associated with a seemingly safe investment, and it doesn't take into account the surprisingly low historical probability of losses in equities over longer periods.

"Risk-free" Treasury bills create the risk of not achieving financial goals. At a 4% average annual return, an investment in Treasury bills would take about 18 years to double in value. In contrast, from 1950 through 2004, the S&P 500 produced an average annual return of 12.1% a year. That includes the challenging period of the 1970s, as well as the first three years of this decade, which saw the worst decline in equity prices since 1941.

In 15 of the 55 calendar years from 1950 to 2004, small-cap stocks did produce negative returns. Large-company stocks produced negative returns in 12 of those 55 years. However, the worst return in any 10-year period was 3.2% for small-caps and 1.2% for large-caps. In their worst 20-year period, small-company stocks produced an 8.2% average annual return, which is better than the best average annual return for Treasury bills in any 20-year period since 1950.

In our firm's target-date products, we use an initial allocation of 100% equity, including emerging markets, for investors targeting a goal 20 years away. For a 10-year time frame, the initial allocation is 80% equity, 10% real-estate investment trusts and 10% fixed income. For a core portfolio used by retirees, we maintain an allocation of 55% equity.

Charles W. Kadlec
Managing Director, J&W Seligman
New York City