The Mutual-Fund Retirement Kit

Would a lifecycle fund that focuses on retirement be a good investment for my 43-year-old son?

QUESTION: What do you think of the Fidelity Freedom 2020 fund (FFFDX) as a retirement fund for my son, who is 43 years old and self-employed, with no retirement pension? If this were his only fund, would it be a wise choice?

ANSWER:

Fortunately, the retirement options available to the self-employed are quite generous. And, assuming that your son has little interest in actively managing an investment portfolio, investing in a so-called target-retirement fund, such as Fidelity Freedom 2020, could indeed be a very smart move, says Don Cassidy, senior research analyst at fund-tracking firm Lipper.

Target-retirement funds fall into a broader category of mutual funds known as lifecycle funds. These offerings attempt to create a diversified portfolio -- with just one fund. They do so either through direct investments in stocks and bonds, or by purchasing shares of other mutual funds. Both Fidelity's Freedom funds and Vanguard's LifeStrategy portfolios, for example, take the "fund of funds" route. But regardless of exactly how the portfolio is created, you should keep in mind that as a group, these tend to be fairly conservative investments. For example, the Vanguard LifeStrategy Growth fund (VASGX) -- the company's most aggressive lifecycle fund -- invests more than 20% of its assets in bonds.

Target-retirement funds, in turn, focus on a specific goal, namely retirement during a specific year. (They're offered by only a few firms, including Fidelity, Barclays Global Investors and Wells Fargo.) The idea: You choose a fund with a so-called maturity date that matches the year you expect to retire. The fund will slowly adjust its asset allocation over time toward a more conservative mix, starting with an emphasis on growth and shifting to a goal of preservation of capital as it approaches maturity.

So what happens when a target fund reaches its goal? Quite frankly, not a whole lot. To save investors from an ugly tax hit, these funds don't liquidate when they reach maturity. For example, the Fidelity Freedom 2000 fund (FFFBX), which reached maturity last year, recently held approximately 37% of its assets in bonds, 35% in cash and 27% in stocks. This fund will continue to become more conservative over the next four to nine years, until it achieves the asset allocation of the Fidelity Freedom Income fund (FFFAX) and is merged into it.

Now, if this is your son's only retirement plan aside from Social Security, he might want to be a little more aggressive with at least part of his money. Lipper's Cassidy suggests that he might want to consider placing one-third of his money in the Fidelity Freedom 2030 fund (FFFEX), which, since it has a maturity date 10 years later than the 2020 fund, will maintain a growth-oriented stance for longer. Or he might want to put some money in a different type of fund altogether, says certified financial planner Sue Stevens, Morningstar's director of financial planning. Since the Fidelity Freedom 2020 portfolio focuses on large-cap and growth stocks, Stevens suggests a small-cap value option such as the Fidelity Low-Priced Stock fund (FLPSX) (if he wanted to stick to the same family). Consider this: While Fidelity Freedom 2020 is down almost 8% year-to-date, Fidelity Low-Priced Stock is up more than 17%. Without a second fund, a year like 2001 could truly test a single-fund investor. "If this is your entire life savings and it's going down, it's going to be difficult," says Stevens.

Stevens also recommends gaining as much "tax-deferred power" as possible. One option is for your son to open a SEP IRA, which is designed for small businesses and self-employed workers. Should his income allow it, Roth IRAs can also help his fund earnings grow tax-free.

Finally, even if your son holds only one or two funds, that doesn't mean he shouldn't pay attention to fees. Because it's a "fund of funds," Fidelity Freedom 2020 has a more complex fee structure than your average fund. Its expense ratio of 0.08% is paid on top of the annual fees paid to the underlying Fidelity funds in the portfolio. Even so, the total combined expense ratio for the portfolio is just 0.85%. That's far less than the 1.24% category average for large-cap blend funds, according to Morningstar.