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Why do marketers love the concept of life cycle?
The concept of understanding life cycle and life stages has been popular among marketing strategists. People have different needs and wants at different stages of their life cycle - and marketers devote a lot of their time and energy in understanding the unique needs of each stage in the life cycle, so that they can design solutions that cater to these unique needs. Life stages are many - and include infants, early school going, teenagers, college going students, in early jobs, recently married, families having young children, families with teenage children, empty nesters, pre-retirement couples, early retirement and old age. Think of a dairy products company : it produces baby milk powder for infants, vitamin enriched milk for growing children, full fat milk which is ideal of young adults and low fat versions that find appeal among middle aged and senior citizens. The product in essence is the same : its milk. But, variants are produced to cater to different needs at different life stages.
Life cycle applied to financial products
Just like individuals have different needs at different stages of their life for something as basic as milk, so also they have different financial needs and goals at different stages of their life. In a family consisting of a retired couple, their married son and daughter-in-law and their grandchildren, each generation has very different financial needs - at the same point of time, and need financial solutions that are tailored to meet their specific requirements. The retired couple need steady income to remain financially independent even within a joint family, the young couple need wealth creation solutions to help fulfil their soaring ambitions and the young children need savings plans that will help finance their education. Financial planning is all about helping investors articulate these needs and goals and planning their finances in a manner that helps achieve these financial goals.
Not every individual has access to a financial planner who can help them organise their finances in a goal oriented manner. This is where financial product manufacturers have stepped in, world-wide. Financial product manufacturers - insurance companies and mutual funds - have come to recognise the power of producing solutions that revolve around the concept of life cycles. Instead of offering vanilla equity and debt funds and leaving it to the individual to figure out what combination works best for them at different stages of their lives, manufacturers have created solutions that change their contours to suit the typical needs of the individual as he progresses from one life stage to another.
What are Life Cycle Mutual Funds?
Investopedia defines life cycle mutual funds as, "A special category of balanced, or asset-allocation mutual fund in which the proportional representation of an asset class in a fund's portfolio is automatically adjusted during the course of the fund's time horizon. The automatic portfolio adjustment run from a position of higher risk to one of lower risk as the investor ages and/or nears retirement."
Life-cycle funds may be considered as the closest thing the mutual fund industry has to a "fill-it, shut-it, forget-it" , maintenance-free investment solution. Life-cycle funds, also referred to as "age-based funds" or "target-date funds," are a special breed of the balanced fund. They are a type of fund of funds structured between equity and fixed income/ debt funds. The distinguishing feature of the life-cycle fund is that its overall asset allocation automatically adjusts to become more conservative as the expected target date approaches.
Life cycle funds are typically structured as fund-of-funds (FoFs) - which invest into established debt and equity funds with a good track record within the fund house, in proportion to the typical requirements of each life stage. The benefits of such products are that investors need not keep rebalancing their portfolio on the basis of market movements or changing life stages and need not have to regularly track them. Life-cycle funds give the convenience to investors of putting their investing activities on autopilot through the use of just one fund, which is managed for them. The limitation of most of these products is that manufacturers typically allocate all money to their own schemes, and thus the investor does not get the benefit of diversifying across fund houses to reduce risk.
There is of course another solution, which is multi-manager products. Here, the designated fund manager is mandated to allocate across schemes of different fund houses, on the basis of fund research processes that are well defined and monitored. The multi-manager product essentially takes over the role of an advisor from a fund selection point of view.
In developed markets, life cycle mutual fund products are quite popular. A recent report from PricewaterhouseCoopers suggests fund houses in India need to come up with more such products.
On the other hand, critics of these funds say that their "one size fits all" approach is suspect. This debate is similar to evaluating tailored clothes versus readymade clothes. Which one is better? Tailored clothes clearly can give you the fit that suits you best. They may often be a costlier option than readymades. In the ready made solution, you pick the size range that is a best fit - but is rarely an exact fit. Ready mades are quick and convenient to buy, tailored clothes means more effort - of buying the cloth, getting your measurements taken, deciding the cut and style, going for a trial and finally getting your clothes delivered. For some, the effort is well worth the while, for others, its too much of a bother. Importantly, the same individual may choose readymade clothes for casual and work wear, but may insist on getting his or her wedding dress tailored to perfection. When it matters most, you go for the expert solution, at other times, you are ok with a "one-size-fits-all" solution.
How are life stage products different from life cycle products?
Life stage funds are essentially a sub-set of life cycle funds. They are designed to cater to one particular life stage only. A children education fund for example is a life stage product that focuses only on that one stage of the life cycle of an individual.
Another variant which is quiet popular in the US is target date funds. A target date fund need not necessarily cater to your entire life cycle, but can be a product that fits conveniently into a need that you expect to have around the given target date. For example, there can be a target date 2020 fund, where you can start an SIP, say in 2014. Since the target date is 6 years away, this fund may allocate a majority of the SIP amount towards equity. As the year 2020 approaches, it keeps enhancing its debt allocation, until a level of say 100% by the year 2019. In 2020, it would typically be fully in cash, to allow you to redeem without any nasty surprises induced by market volatility.
If a fund house has a set of target date funds say 2020, 2025, 2030, 2035 and so on, you can invest in the appropriate fund that matures in the year in which you expect to have a major financial obligation. An investor could for example invest in a Target Date 2020 fund for his children's education and also into a Target Date 2040 fund for his retirement.
How can investors benefit from them?
Financial Literacy is an issue which even developed countries are groping with. In US only 5 per cent of the population can be called as financially literate. It can be easily understood that in a country like India the per cent of financially literate people are miniscule, even amongst the literate middle class. Therefore, the Ministry of Finance have started two ambitious projects, one is popularly known as Financial Inclusion, where they will like to have that each and every Indian will have a bank account and the other project is to introduce financial education in schools.
Lack of financial literacy is one of the reasons that only 3 per cent of household funds have been invested in Mutual Funds. According to a survey done by Invest India Economic Foundation on financial literacy-2002 in India, 60% respondents did not know the current value of their portfolios while around 40% had never calculated the full value of their portfolios. Of the respondents who had calculated the value of their portfolios in the past, 28% calculated the value on an annual basis while a quarter did this on a monthly basis. This data is about the financially literate who have invested in mutual funds products.
The second reason is despite financial literacy, age is a factor, which prohibits people to keep on investing in mutual funds simply for the reason they find it difficult to monitor their mutual funds portfolio.
Life cycle and life stage funds are solution to the above two challenges. As life-cycle funds are convenient and simple, they have gained popularity in the west and are gaining popularity in India. Many retail investors are overwhelmed by the responsibility of managing their retirement portfolio and by the bewildering number of investing options facing them. These funds prevent investors from acting unnecessarily on their own and trading frequently. Life-cycle funds make life easy for investors seeking a solution that delivers simplicity, focus and peace of mind.
The other advantage is that based on an investor's age, these funds provide an option to put money in schemes with different asset allocations, and which is essential to life-cycle investing. Investors in their 20s can go for an aggressive or a very aggressive fund and someone in the 50s can go for a conservative or a very conservative fund. However, the funds do not offer automatic switching between plans. As such switching is treated as redemption and had tax implications.
If investors had to shift between funds, it would attract capital gains tax and exit load. In a life cycle products, there is no such liability. Also, when a fund manager invests, he takes into consideration the cash level and the equity-debt ratio of each fund in the portfolio. The life cycle product is structured in such a way that the equity-debt ratio and the cash level of individual funds should not affect the overall mandated allocations.
Life cycle funds will not enjoy the preferential tax treatment offered to equity and balanced funds, as there are times when these funds have less than 65% invested in equity. However, one can argue that the discipline of staying invested in such an auto-pilot fund may offset over long periods of time, the relative tax disadvantage of being treated as a debt fund.
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