Life Cycle Funds - Meaning, Benefits, Example, How it works (2024)

Lifecycle funds, also known as target-date funds, are investment funds designed to provide a diversified portfolio that automatically adjusts its asset allocation over time according to a predetermined target retirement date or other financial goal. For example, a person planning to retire in 2050 might invest in a "2050 Fund." Initially, this fund might have a higher allocation to stocks to take advantage of their growth potential over the long term. As the target date approaches, the fund manager will gradually decrease the allocation to stocks and increase the allocation to bonds and cash, which are typically less volatile.

What is a life cycle fund?

A life cycle fund is a specialised mutual fund, also known as an age-based or target date fund. It is designed so that asset allocation is done automatically based on an investor's retirement date. If you are a long-term investor, life cycle funds will be particularly helpful for you. Life cycle funds are becoming increasingly popular because they are structured to provide returns while managing risk.

How do life cycle funds work?

A life cycle fund works in 3 distinct steps. We elaborate on these steps with an example below:

• Step 1: Aggressive asset allocation during early investment stage
  When you are in your 20s or 30s, your risk tolerance level is high. So, the fund manager will allocate a higher percentage (say, 80%) of the fund in stocks.
• Step 2: Mid-life reallocation
  As you invest for 15 years or more, you enter your mid-40s. Now, you have a family of your own and a lot of responsibilities. You have progressed halfway towards your retirement. With less time to approach retirement and increased responsibilities, your risk tolerance level has come down. So, your fund allocation to equities has to be decreased so that your risk exposure can be lowered.
• Step 3: Conservative asset allocation
  With just a few years away from your retirement, your fund’s exposure to equities is withdrawn completely. Instead, the proceeds are invested in assets that provide you with assured returns. This helps to avoid any potential loss to your corpus, which has been created after so many years of investment.

Example of life cycle fund allocation

Let us assume you are in your early 20s. You started investing in a life cycle fund in 2020 and pledged to continue until 2050, so you will remain invested for 30 years.

• In the aggressive asset allocation stage, 80% of your funds are allocated to stocks and just 20% to debts, bonds, and other low-risk assets.
• In 2035, you will be around 35 years of age. As you have more responsibilities, your allocation to equities will decrease to 60%. However, the same for bonds will increase to 40%.
• In the final stage, when you reach retirement age or the target year of 2050, 40% will be allocated to equities and 60% to bonds.

Benefits of investing in life cycle funds

1. Automatic rebalancing
   Over time, the asset allocation for your life cycle fund changes automatically. No active rebalancing of funds is needed.
2. Risk management
   The life cycle funds reduce their exposure to risk as their target or retirement year approaches. This helps preserve their corpus and shields them from unexpected losses.
3. Ideal for achieving long-term goals
   The best thing about this fund type is that you can decide a percentage of your savings as per your comfort level and then stay invested for 30 years. The automatic rebalancing happens and your investment grows without you worrying about returns or losses.
4. Simplicity and convenience of investing
   The approach to life cycle funds is simple. As a first step, you have to select a fund based on your desired year of retirement. You simply have to decide on the glide path; the fund manager will do the rest.
5. Transparency
   As you can preset the glide path, you can remain confident about your investment. In addition, you will know everything about your investment in different assets.

Should you invest in a life cycle fund?

Life cycle funds automatically adjust the asset allocation to match an investor's risk tolerance as they approach retirement. These funds offer the convenience of having a set-and-forget retirement plan, but investors should be aware of their shortcomings. The key advantages of lifecycle funds include:

• Convenience: Investors can easily put their investments on autopilot without needing to constantly monitor and adjust their portfolio.
• Diversified portfolio: Life cycle funds provide a diversified portfolio with a mix of stocks, bonds, and other securities, which can help manage risk and generate consistent returns.
• Risk reduction: As the investor approaches retirement, the fund automatically reduces its exposure to stocks and increases its allocation to bonds and other low-risk investments, helping to preserve capital.

Who should invest in life cycle funds?

Life cycle funds are suitable for investors looking for a straightforward and hands-off approach to retirement planning. These funds are designed to automatically adjust their asset allocation based on the investor's target retirement date, ensuring that the portfolio becomes increasingly conservative as the retirement date approaches. This approach is particularly beneficial for investors who:

• Are new to investing and lack the expertise to manage their own portfolio
• Have limited time to devote to managing their investments
• Are unsure about how to allocate their assets between stocks and bonds
• Are looking for a low-maintenance option that can provide a steady income stream in retirement

Investors nearing retirement or having a specific retirement date in mind can benefit from the preset glide path of life cycle funds. These funds are also suitable for investors who want to take a passive approach to retirement planning and are willing to accept the potential limitations of this approach.

Limitations of Life Cycle Funds

However, life cycle funds also have some drawbacks, which include the following:

• Fees: Life cycle funds often come with higher fees compared to simple index funds, which can eat into returns over time.
• Limited flexibility: Investors have limited control over their investments, as the fund manager makes decisions based on the predefined glide path.
• Assumptions: Life cycle funds assume that the investor's only source of retirement income is the fund itself, which may not be the case for investors with other sources of income.

Investors should carefully evaluate the fees and potential limitations before investing in life cycle funds.

Summary

The ideal investors for life cycle funds are young investors with targeted goals and those who look for the convenience of passive investing (through fund managers). Some people may confuse a life cycle fund with a mutual fund. However, they are not the same. While life cycle funds are specialised funds for retirement planning, mutual funds offer greater personalisation opportunities to achieve multiple financial goals.

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