Life cycle funds or age based funds are a class of funds, which structure their asset allocation based on the age of an investor. As the age of retirement approaches, an aptly nominated life cycle fund can be made more conservative by selling stocks and purchasing more fixed income investments, thereby reducing the risk of the earlier investments and making the fund more suitable for the lifestyle after retirement.
Life cycle funds were first introduced by the US Federal Government through an account called the Thrift Savings Plan, which has now become a fund managed by the private fund management companies.
The working of the life cycle fund is easy to understand. As the year of the retirement approaches, the behavior of the asset becomes more and more conservative, and it starts investing in safe government bonds and other fewer risky funds including the income related funds. This model of investing follows the traditional practice of reducing risk as you approach the age of retirement.
Life cycle funds are very transparent in nature, and they advise an investor about the structural changes of the fund and start an automatic diversion of the allocation of the funds. For example, if an investor is about to reach retirement in a period of 10 years, and the fund is nearing its completion stage then the fund manager allocates the fund in safe return funds in order to reduce the risk.
Life cycle funds are of two types:
• Target - Date fund
These funds operate on the basis of a date chosen by an investor. If an investor selects a specific year as his retirement year, then the fund automatically adjusts its risk appetite and fund allocation as the retirement date approaches. For example, if an investor has chosen the year 2050 as his retirement, the fund will start reducing the risk and start investing in income related funds and other safe fund options such as government bonds from the year 2045.
• Target - Risk fund
The target risk fund has three allocations based on the risk appetite of an investor. The fund is divided into three categories i.e. conservative, aggressive and moderate risk appetite. An investor also has the option of switching to a different risk allocation at a later stage or when he realizes that the risks are too much for him to handle.
The advantage of this life cycle fund is that an investor can relax after investing in this fund. Nevertheless, he should also be aware of the fund’s shortcomings. Not all life cycle funds follow the same method of investing, hence, the investor should be careful and be well aware of the nature of the life cycle fund. A life cycle fund can also be referred to as a fund which suits all but is not an alternative to an investor’s customized retirement plan. An investor should do all the research properly and select the type of life cycle fund which ensures a comfortable and hassle-free retirement.