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Although lifestyle funds are designed as a no-hassle approach to help less sophisticated investors build tailored investment portfolios, new research by Hewitt Associates shows that some 401(k) plan participants may be using these funds in ways that defeat their intended purpose.

Even though lifestyle funds are intended as turnkey investment solutions where 401(k) participants simply match up their time horizon and risk preferences with a single fund, such as a conservative, moderate or aggressive lifestyle fund, the research shows that few 401(k) participants are using the funds this way. In fact, the study shows that participants are mixing lifestyle funds with other funds, resulting in homogeneous portfolios, regardless of age and years left until retirement.

"It's clear that 401(k) participants are not using lifestyle funds as a one-stop shop," said Lori Lucas, defined contribution consultant for Hewitt, a global management consulting and benefits delivery firm based in Lincolnshire, Ill. "Our research indicates that many participants combine lifestyle funds with other funds because they view lifestyle funds as `just another fund option. One result is that the average young participant using lifestyle funds may be overweight in fixed income."

The Hewitt study examined the use of lifestyle portfolios in a U.S. company's 401(k) plan. "Alpha Company's" 401(k) plan has more than 10,000 participants, with approximately 4,000 participants investing in lifestyle funds. The plan offers participants 12 investment options, including three lifestyle funds, each with a different risk level: conservative, moderate and aggressive.

Despite the opportunity to take the guesswork out of investment decisions, few participants in Alpha Company's plan use the available lifestyle funds as a turnkey solution. Of those participants that have some allocation to lifestyle funds, only 12 percent have 100 percent of their non-company stock monies in a single lifestyle fund.

"We found that very few participants were simply matching their risk profile with an appropriate lifestyle fund," said Lucas. "In fact, many participants who used lifestyle funds weren't choosing one lifestyle fund, but allocating to several lifestyle funds at once. Clearly, lifestyle funds are not being used as the simple, straightforward investment solution they are intended to be."

Mixing lifestyle funds has consequences
Hewitt's study shows that of those participants with some allocation to lifestyle funds, the majority (88 percent) combines the lifestyle funds with other funds available in the plan. Results show that by mixing lifestyle funds with other funds, the average total portfolios of lifestyle participants in their 20s, 30s, 40s, 50s and 60s tend to cluster around the same risk level as that of a moderate lifestyle portfolio.

"It is difficult to argue that the moderate lifestyle portfolio is appropriate for both the average older participant and the average younger participant," said Lucas. "Our evidence suggests that plan participants are not only complicating lifestyle fund investing, but perhaps weakening its effectiveness."

In Hewitt's study, the aggressive lifestyle fund has 20 percent fixed income exposure. However, the typical 20-something investor using lifestyle funds has nearly 40 percent fixed income exposure. By contrast, the average 20-something investor in the plan with no lifestyle fund has less than 30 percent fixed income exposure.

"It is troubling to see that the 20-something participants are ending up with such a conservative allocation as an unintentional outcome of mixing and matching lifestyle funds with other funds," Lucas said.

Participants pay attention to time horizons
Hewitt's research shows that participants do not ignore time horizons when selecting lifestyle funds. Younger participants have a bias toward aggressive lifestyle funds and older participants have a bias toward conservative and moderate lifestyle funds.

Additionally, lifestyle funds do appear to encourage investors who otherwise wouldn't invest in equities, such as older participants, to do so. Investors in lifestyle funds tend to be better diversified in asset classes such as international stock than their non-lifestyle fund counterparts.

"Plan sponsors need to weigh the pros and cons," said Lucas. "There's no doubt that some participants benefit from lifestyle funds. However, the key is making sure lifestyle funds are not confusing, rather than helping, participants. If participants end up with portfolios they really don't understand or didn't intend to have, that can be a detriment to their investment peace of mind."

The Hewitt study notes that companies can restructure lifestyle funds so that participants are required to invest 100 percent in the lifestyle fund of their choice. Alternatively, plan sponsors may wish to consider offsetting the mix and match mentality by making the conservative and aggressive lifestyle funds better differentiated in terms of equity allocation. Lucas adds that ample communication and education about the purpose of lifestyle funds is imperative.

"In order to use lifestyle funds effectively, participants need to understand how these funds can facilitate wise investment choices," she said. "If not, plan sponsors looking to serve the less sophisticated plan participant may need to look at other options, such as third party investment advice."

Edited by Steve Tarnoff