With the flood of lifecycle funds available in the market, plan sponsors need to consider which funds are most appropriate for their retirement plan.

Some factors to examine are:

• A distinct return/risk profile for each fund to facilitate participant communications and decision-making.
• Sufficient equity or other risky asset exposure during the accumulation years and retirement years to reduce the risk of not saving enough or outliving savings.
• Sufficient fixed income/cash allocation close to or in the retirement years to minimize exposure to equity capital losses.

• Much has been written about how the proliferation of fund options in defined contribution plans may lead to "analysis paralysis," in which participants are overwhelmed by the number of choices and choose not to participate in the 401(k) plan at all or make an inefficient allocation, such as putting all their assets in one fund option.

By offering lifecycle funds, plan sponsors can make it easier for participants to select an appropriate portfolio that optimizes their risk/return preferences. Plan sponsors must make four decisions in choosing lifecycle funds for their DC plans:

• 1. Selecting target-date or target-risk funds.
  2. Customizing the plan's core funds or using an off-the-shelf product.
  3. Using actively managed or indexed underlying strategies.
  4. Selecting a fund with or without a tactical asset-allocation component.

Target-date vs. target-risk

Target-date funds typically link each investment portfolio to an expected retirement date, with the asset allocation adjusted periodically to reduce investment risk and protect assets for the retirement years. Target-age funds operate similarly, but instead of focusing on a selected retirement date, the asset allocation changes in tandem with the participant's age.

Target-risk funds (categorized as conservative, moderate or aggressive) maintain a specific asset allocation to provide an even exposure to investment risk. With target-risk funds, participants typically need to initiate transfers to more conservative funds as they approach retirement.

But with target-date funds, the shift to a more conservative allocation is accomplished systematically by the investment manager. A potential problem with target-date funds is that participants may place too much emphasis on the date in the fund's name when deciding their selection. For example, a 2030 fund may not be appropriate for all participants expecting to retire in the year 2030.

Depending on a participant's circumstances - such as investment assets outside the plan, spending habits or the value of their home relative to the mortgage - a more aggressive or less aggressive fund may be a better fit. This issue should be addressed through targeted employee communications.

Custom vs. off-the-shelf

Meanwhile, there is increased interest in custom lifecycle funds. A plan sponsor's custom lifecycle fund uses a combination of the plan's core funds, thus ensuring that the same group of funds is offered to all participants.

When selecting a plan's off-the-shelf lifecycle product, participants may not have access to all the same funds that their employer has selected and monitored. While employers do select and monitor the off-the-shelf fund, investment managers control the selection of underlying funds. This arrangement has some disadvantages.

For example, a second set of funds needs to be communicated to participants, along with the employer's reasons for not making the same underlying funds available to all. If the underlying funds are all from the manager's proprietary fund family, this may limit diversification.

Effectively monitoring all the underlying funds with the lifecycle fund, in addition to the core lineup, can place a strain on the employer's resources.

A customized approach provides the opportunity to include higher-risk and alternative asset classes in a lifecycle vehicle. This can be more appropriate than having these asset classes as a standalone option, and their risk can be minimized, since the lifecycle vehicle will be highly diversified.

Plan sponsors should consider the additional costs associated with creating and managing a custom lifecycle-funds program, compared to an off-the-shelf product. Plans of sufficient size construct their lifecycle funds using separate and commingled accounts, rather than mutual funds. The use of these vehicles may offset some or all of these costs through lower investment management fees. Such costs include custody fees for creating a daily net asset value, consulting fees for developing and updating the asset allocation strategy, and fees for customized employee communications.

There's also the issue of fiduciary risk in a custom program, since the plan sponsor needs to develop the asset allocation and roll-down strategies (resetting the target asset allocation over time by shifting assets out of stocks and into bonds and cash), thus opening the door for criticism if they turn out to be unsuccessful.

Where creating custom lifecycle funds is desired, but not practical, some plan sponsors are turning to indexed or passive off-the-shelf lifecycle funds. Even where custom funds are feasible, the plan sponsor may prefer an indexed strategy.

Actively managed vs. indexed underlying strategies

This approach mitigates the issue of the underlying funds differing from the core options. Although the underlying funds would still differ, investment risk and the monitoring resources required are substantially smaller than with actively managed funds. Participants who prefer lifecycle investing may prefer indexed strategies. Lifecycle investors seek to minimize their active involvement.

With index funds, there is minimal risk of style drift or underperformance due to active management decisions. On the other hand, there are disadvantages to indexed lifecycle funds. Participants choosing these funds do not benefit from active management, which can outperform passive investing. Fund expenses ensure passive lifecycle funds will always underperform their benchmark on a net-of-fee basis.

It may be difficult to obtain exposures to asset classes that can offer diversification benefits but are not easily indexed, such as real estate or infrastructure.

Tactical asset allocation?

Lifecycle funds may strictly adhere to or tactically deviate from their asset allocation targets, based on the manager's market outlook. Tactical shifts are usually enacted within a narrow range.

Most lifecycle funds adhere to their target allocations to avoid producing an allocation that no longer reflects the lifecycle investor's desired return/risk profile. Managers want to avoid the risk of underperforming due to poor tactical decisions. However, a manager with strong tactical asset allocation capabilities can add value while maintaining an allocation close to the strategic targets for each target year.

These decision surrounding choosing lifecycle funds for DC plans can go a long way toward helping plan participants in assembling an optimal risk/return profile for their investment portfolios. This strategic approach to choosing the right lifecycle fund may seem complicated, but the potential for better serving your plan participants makes it worth the effort.

Michael Kaplan leads Mercer's defined contribution investment consulting business in the U.S. Northeast region.