Watson Wyatt: Lifecycle Funds Better QDIA Bet Than Balanced Funds

March 26, 2007 (PLANSPONSOR.com) - Lifecycle funds came out ahead of balanced funds, according to a recent comparison of the two by Watson Wyatt Worldwide, because the lifecycle funds do a reasonable job of creating retirement wealth and a better job of mitigating the downside risk.

The analysis  by the consultant sought to find out which type of funds would likely deliver a more secure retirement for defined contribution plan participants.  Balanced and lifecycle funds were sanctioned as a default investment alternative by the Department of Labor (See DoL Releases Default Investment Option Safe Harbor ).

Through a series of simulations, Watson Wyatt found that the balanced fund is slightly more likely to outperform the lifecycle fund in terms of returns, but the aggressive approach leaves plan participants more vulnerable to losses as they approach retirement. The lifecycle fund is better at safeguarding wealth in a downward market, while still doing a reasonable job of building wealth; however, it shifts assets to cash at retirement, so the typical lifecycle fund forgoes hedging opportunities for the purchase of immediate life annuities.

However, Watson Wyatt asserts that the lifecycle fund has an inherent weakness in that it shifts rapidly to money market investments toward the end. If a plan participant purchases an immediate life annuity, assuming such a large cash position implies fewer hedging opportunities, that leaves the individual vulnerable to considerable volatility in annuity prices arising from changing interest rates.

“With the employer shift toward DC plans, more workers are relying on 401(k) plans as their primary source of retirement income outside of Social Security,” Watson Wyatt suggests in a press release. “When designing or selecting default investment options, sponsors should thoroughly consider the investment implications of the above analysis, as well as specific participant characteristics, such as wage patterns, risk tolerance, demographic characteristics and whether there is also a DB plan.”