Target date portfolios can reduce the risk that unexpected market swings pose to your retirement savings by managing risk throughout your life.
Can target date portfolios be a more effective way to balance risk and return than risk-targeted balanced portfolios?
To take the guesswork out of investing, many investors pour their retirement savings into risk-targeted balanced portfolios, which diversify holdings into stocks, bonds and cash. Doing so is easy, but it carries a downside: Since the mix of holdings in balanced portfolios is static, investors can find themselves overexposed to risk if they do not monitor and adjust their investments periodically.
"People own those portfolios for years and sometimes never get away from them," says Robert Garcia, Chief Operating Officer of the CGCM Funds and CGCM Retirement Target Date Portfolios. However, for investors who would rather not reassess and tweak their portfolios every year, target date portfolios may be a more effective way to invest. These portfolios take into account the year in which you plan to retire and reduce your exposure to riskier investments as you near that date, limiting the chance that a market shock wipes out a substantial portion of your portfolio as you're getting ready to cash out.
Unlike balanced portfolios which are static, target date portfolios adjust equity and fixed income exposure continually during the life of the investment, using the investor's distance from retirement as a guidepost. A portfolio targeted for a younger investor—shooting to retire in, say, 2055—might allocate between 96% to 76% of holdings in equities, while those nearing retirement might hold 40%.
Instead of making the adjustments every year manually, and perhaps making some prudent (or imprudent) tweaks, a target date portfolio will change the mix gradually and automatically, seeking to optimize holdings throughout the life of the investment.
"Instead of trying to understand what your risk level should be throughout your life, target date portfolio will adjust automatically on your behalf," says Garcia.
Looking at the years since 1900, research shows that, over a 20-year period, equities performed worse than bonds in only one out of 20 time periods by an average of 1% annualized. But when comparing markets on a year-over-year basis, equities underperformed bonds nearly two out of every five years by an average of 15%. In some years, such as in 2008, equities underperformed by more than 40%. A static balanced fund can leave investors overexposed to equities during volatile times and, that matters especially in the years closer to retirement.
There are several factors within target date portfolios to consider. Portfolios are made up of underlying funds and those funds can be either actively managed or passive funds, such as ETFs, or a combination of both.
Target date funds can also be open or closed architecture. Meaning, some managers stock their target date portfolios with only their own proprietary products (closed), while others, Morgan Stanley included, have no such restrictions (open).
One of the biggest benefits of a target date portfolio may be how they handle the biggest risk to a retirement portfolio: sequence of returns.
To explain sequence of returns, consider how two portfolios—one using a balanced fund with a static 55% equity and 45% bond allocation, the other using a target date fund—might fare under the following two circumstances.
In scenario one, imagine a decade of poor market performance (the 1970s), followed by 20 years of good market performance (1980s and 1990s) and then a decade of terrible market returns (2000s).
Scenario two assumes a different order of events: The worst returns happen during the first decade, followed by 1970s-like returns the following decade, and ending with the best returns during the last two decades.
In a balanced portfolio the difference in the final portfolio value could vary vastly from scenario one, where the worst performance happens later in the investment period, to scenario two, where it happens early on. On the other hand, the final portfolio value of a target date fund is considerably less effected from one scenario to the other. In practical terms, this could mean that if a market shock occurs later in life, investing in a target date portfolio versus a balanced portfolio could be the difference between having enough money during retirement and falling short.
While all target date portfolios manage sequence of returns risk to some extent, Morgan Stanley looks at current and projected market conditions as well, drawing on research from Morgan Stanley's Global Investment Committee. If the committee forecasts a rough upcoming two to three years, the target date fund can pull back slightly on equity exposure.
"We want to make sure that, regardless of when you want to retire, you're not put in a bad situation for retirement funding," says Garcia.
For many investors, target date fund portfolios can be a valuable tool in an overall retirement strategy. Talk to your Morgan Stanley Financial Advisor today (or find one here) to talk about Target Date Portfolios and other options that can be an integral part of your wealth management plan.