Keeping it Simple: White Paper. Lifestyle Funds: A Streamlined Approach

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1 Keeping it Simple: Lifestyle Funds for Retirement Planning Retirement investors who suspect that things are more complicated than they used to be can take heart from the findings of a new study by American Association of Retired Persons (AARP): you are not alone. In Beyond 50.04: A Report to the Nation on Consumers in the Marketplace, AARP s researchers conclude that the marketplace has become more complex than it was a generation ago, that change is rapid and continuous and that decision-making has become increasingly difficult a combination that raises challenges for retirement investors of all ages. The study singles out three primary factors behind this trend: Consumers have more decisions to make and less time to make them. The range of products and services available to them is steadily increasing in both number and complexity. In general, consumers suffer from low levels of financial literacy. AARP looked at many aspects of consumer activity in the new study, including savings and investments. While it is not possible nor would it necessarily be desirable to turn back the clock to a time when life was less complex, AARP advocates an approach to saving and investing that stresses simplicity. According to AARP, key aspects of such a strategy may include maximizing contributions to your 401(k) plan and relying on mutual funds as your basic investment vehicle. Mutual funds are currently the most widely used investment vehicle for 401(k) investors. On average, at year-end 2003, 82 percent of 401(k) plan participants assets were invested in mutual funds. 1 And, the average number of investment choices offered within a 401(k) plan continues to rise. With all the investments available, choosing from the thousands of funds can be overwhelming. As a result, communication efforts to educate investors about the various fund choices has become more challenging. This paper seeks to explore the world of lifestyle funds, the latest fund trend available to 401(k) investors. Lifestyle Funds: A Streamlined Approach For retirement planning or for simple diversification needs, lifestyle funds are an emerging trend and include both asset allocation and target-retirement funds. Both generally offer asset allocation, using a mix of underlying funds designed to provide broad asset class diversification. This approach is called a fund of funds. Timing of Purchases/Sales 1.8% Other Factors 2.1% Security Selection 4.6% Why do most lifestyle funds use asset class diversification? History shows that a significant percentage of the variability of investment performance is driven by asset allocation decisions or combining asset classes such as equities, fixed income and cash in varying proportions within a diversified investment portfolio.* Asset Allocation 91.5% Keep in mind, diversification does not protect an investor from market risk, and does not ensure a profit. Factors such as when investors commit assets and which securities they buy are believed to have a relatively small impact on long-term investment results.* *Source: Financial Analysts Journal

2 It is also important to remember that asset allocation and target-retirement funds are not tax-deferred investment vehicles, but they are appropriate investments for tax-sheltered accounts such as IRAs and employer-sponsored retirement plans. Target-retirement funds do provide similar benefits in a taxable account relatively low costs, professional management and diversification but their suitability in a taxable account depends on investors' individual tax situations. There are significant differences in the complexity and level of diversification offered by the two most common types of lifestyle funds: asset allocation funds and target-retirement funds. Asset Allocation Funds Asset allocation funds are designed to incorporate a comprehensive diversification strategy in one simple step by investing in a variety of mutual funds from different asset classes. Asset allocation funds tailor their underlying investment mix to match an investor s risk tolerance, as well as time horizon with portfolio options ranging from conservative more heavily weighted in fixed income and cash to aggressive more heavily weighted in domestic and international equities, and are rebalanced periodically to monitor risk and market exposure. Factors considered when deciding an investor s risk tolerance include investment time horizon, current income levels, current savings, income needs at retirement and willingness to accept portfolio volatility. Asset allocation fund managers take these factors into account when deciding the underlying mix of asset for the funds they offer. Client profile questionnaires are often provided by the fund managers to help investors determine which asset allocation fund within a fund family may be right for them. The goal of asset allocation funds is to provide investors with diversified holdings and consistent returns, while sparing the investor the trouble of continually monitoring market fluctuations and selecting the appropriate investment mix to meet individual s needs. Some asset allocation funds have specific breakdowns of asset classes that they try to maintain over time, while others vary the investment composition as opportunities and circumstances change. Asset allocation funds represent different levels of return at different levels of risk. According to modern portfolio theory, it is optimal to identify what you, as an investor, deem an acceptable level of risk to incur, and then find an investment (or portfolio of investments) that may provide the maximum return for that level of risk. The risk-return efficient frontier illustration shows that when the underlying mix of funds changes in an asset allocation fund, so does the risk tolerance. A fund investing in 40% equity/60% fixed income will be generally less risky and offer lower return potential than a more aggressive fund with 80% equity/20% fixed income. Long-term strategic asset allocation is the primary source of risk and the corresponding primary determinant of total return. Efficient Frontier Expected Return Least Aggressive Strategy 40% equity / 60% fixed income Most Aggressive Strategy 100% equity 80% equity / 20% fixed income 60% equity / 40% fixed income For illustrative purposes only. The efficient frontier is a graph representing a set of portfolios that maximize expected returns at each level of portfolio risk. Each point of the efficient frontier curve represents a portfolio that achieves the highest return at the given level of risk. The standard deviation, as applied to a variable investment portfolio, is a statistical measure of the historical volatility of a portfolio. The greater the standard deviation, the greater the portfolio s volatility. 2 Risk (Standard Deviation) These are only target allocations. Strategy ranges and investments may change over time.

3 The table below represents a hypothetical illustrationof the range of asset allocation fund investment options available to suit a variety of investor profiles. Seek the advice of your retirement services provider to determine which asset allocation fund may best suit your investment needs. Individual Investor Needs and Examples of Suitable Asset Allocation Fund Options Expected Investment Sample Asset Allocation Fund Age Salary Retirement Age Time Horizon Current Savings Investment Objective (Underlying Investment Mix) 45 $100, Years $50,000 Potential to protect principal 60% Equity / 40% Fixed Income while minimizing risk Keep pace with inflation 45 $50, Years $50,000 Grow assets 80% Equity / 20% Fixed Income Accept some volatility Moderately outperform inflation 45 $50, Years $0 Maximize returns 100% Equity Outperform inflation Target-Retirement Funds A target-retirement fund also provides diversification through investing multiple asset classes, and changes its asset allocation as it reaches maturity, or the target date that is often included in the fund name. Target-retirement funds tailor their underlying investment mix to match investors anticipated year of retirement. The goal of target-retirement funds in the initial years of investment is to grow and expand an investor s assets with a more aggressive allocation a higher equity-to-fixed income ratio. As time goes on, and the retirement date nears, a more conservative strategy is applied and the investment is reallocated to reflect a higher fixed income-toequity ratio. Once the fund reaches its target year, preservation of capital becomes the funds primary focus. Typical Rebalancing of a Target-Retirement Fund Over Time: Hypothetical Illustration* Allocation at Inception Final Allocation at Target Date 10% 90% 33% 67% 42% 8% 50% 40% 40% 20% Most aggressive stage Least aggressive stage 2030 Equity Fixed Income Cash *For illustrative purposes only and not intended to represent an actual fund. Although target-retirement funds all share the common goal of first growing and then later preserving principal, they can contain any mix of equities, fixed income and cash, as the fund manager determines appropriate. Once you ve determined your target retirement fund date, it is important not to imply a one-size-fits-all assumption when choosing a target retirement fund. More extensive research is often required of investors who choose these funds. Target retirement funds from different fund families may share the same target retirement date, while 3

4 having quite different underlying asset allocation percentages. The table below represents hypothetical allocations among different target retirement funds with the same maturity dates. Examples of Target-Retirement Funds with a 2005 Maturity Date US Equity Non-US Equity Fixed Income Cash Fund A 39% 7% 37% 17% Fund B 50% 10% 32% 8% Asset Allocation vs. Target-Retirement Funds: Which Lifestyle Funds Are Right for You? Benefits of Lifestyle Funds Offer professional asset allocations designed to deliver automatic diversification and risk management benefits. Create the ability to own broadly diversified portfolio of investments with a relatively low investment minimum. Simplify the retirement planning process by offering the investor a portfolio timed to specific anticipated retirement date or risk tolerance. Factors to Consider: Be aware of the mix of assets held in other types of vehicles, including your retirement plans, to mitigate overlap, or owning the same or similar individual securities or mutual funds in your other investments. Many investors who choose lifestyle funds may not be using them for their intended purpose as a single investment to broadly meet retirement planning and/or investment needs. There is usually a fee included in the fund s total expenses related to the active periodic rebalancing of assets. Fund of funds also absorb the fees associated with the underlying funds, as well as the expenses of the entire portfolio. Thus the cost of this type of investment may be higher than generally experienced when investing in a mutual fund. Lifestyle funds can invest in varying percentages of underlying equity, fixed income and money market investments and are subject to the risks associated with each of these underlying funds. Each lifestyle fund's investment performance is directly related to the investment performance of its underlying funds. An investor may need to change strategies as his or her circumstances and risk tolerance change. Factors to Consider Specific to Target-Retirement Funds: Despite the stated maturity date, they generally do not take into account an individual s age, risk tolerance, income level, or income needs at retirement. Investors will need to project their own expected retirement date. With only one fund offered per expected retirement year, and most fund families only offering choices on a five year cycle (i.e., 2005, 2010, 2015, etc.), the range of variables offered is relatively narrow. Rebalancing of the fund could be timed poorly, e.g., stocks may be on a significant upswing when the fund rebalances away from equities to more fixed income as the fund gets closer to maturity date, potentially missing opportunities for capital appreciation. At the target maturity date, the funds go into their most conservative approach. Since the general population is living longer, these stagnant conservative portfolios may not be able to provide for people living in retirement for 20 or 30 years. 4

5 Risk Tolerance vs. Time Frame Between the two types of lifestyle funds, asset allocation funds focus closely on an investor s risk tolerance and target-retirement funds focus on the investor s time frame. Time Frame Approach: Target-retirement funds generally offer one portfolio for a target-retirement date, i.e., one fund choice regardless of individual s risk tolerance. Investors in early- to mid-career are unlikely to be certain of their retirement date. Consequently, the targetretirement fund may be too aggressive or conservative for their personal profiles. While target-retirement funds offered by different mutual fund companies may have the same maturity date, they may have widely varying degrees of risk. Risk Tolerance Approach: Asset allocation funds maintain a relatively fixed allocation among asset classes or asset categories. Investors choose the fund that is most appropriate for his or her risk tolerance and which most closely complements or fills gaps in their overall portfolio holdings. Changing market conditions create opportunities to capitalize on investing in different countries and asset classes relative to others over time. Asset allocation funds may offer tactical asset shifts away from a strategic benchmark over- and underweighting certain asset classes and countries relative to the benchmark in order to benefit from changing conditions in global capital markets on a regular (e.g., quarterly) basis. Offers more choices to those who may need to catch up their retirement savings potential. Choosing the right lifestyle fund for you, comes down to careful consideration of all investment options available. Each investor's needs are different and not every person can have his or her needs met by one product or portfolio. To learn more about opportunities in asset allocation investments and the importance of diversification, please consult your retirement services provider. 1 Source: ICI Perspective Vol. 10/ No. 2/August 2004 Past performance is no guarantee of future results, which will vary. A prospectus containing more complete information about the Goldman Sachs Asset Allocation Funds may be obtained from your authorized dealer or from Goldman, Sachs & Co. by calling Please consider a fund s objectives, risks, and charges and expenses, and read the prospectus carefully before investing. The prospectus contains this and other information about the funds. At this time target-retirement funds are not offered by the Goldman Sachs Funds. Goldman, Sachs & Co. is the distributor of the Goldman Sachs Funds. Copyright 2004 Goldman, Sachs & Co. All Rights Reserved. Date of First Use: October 27, / WP-68 /

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