Amid the coronavirus bear market, target date funds generally performed in line with expectations, but not all TDFs are created equal and outcomes have varied, according to new research by Morningstar.
In a sign of industry progress, TDFs so far have held up better than they did during the 2008 global financial crisis, though outcome have diverged for near-retirees, the firm notes in “How Target-Date Funds Fared Amidst the Coronavirus Sell-Off.”
Despite diversified portfolios, investors expecting to retire this year (2020 funds) lost more than 17% on average. Individuals expected to retire in 40 years (2060 funds) lost 31%—which is a minor improvement versus U.S. equities, which fell 33%, and global equities, which declined 32%, according to the firm’s data. In general, the report looks at the period Feb. 20 through March 20.
“Investors should be especially cognizant of their target-date fund’s risk profile as they approach and enter retirement, when their nest eggs have likely peaked and they begin to rely on those savings to support their lifestyle,” notes Leo Acheson, Associate Director, Multiasset & Alternative Strategies at Morningstar and author of the post.
And while their diversification benefits dissipated, he notes that that’s not abnormal during extreme selloffs. As such, TDFs have captured more of the equity market’s downside than would be anticipated from their strategic equity weighting which, while counterintuitive, aligns with expectations.
“During more-modest equity sell-offs, bonds typically provide ballast, rising in value as equities fall. But during severe drawdowns, like the ones experienced this year and during the global financial crisis, correlations across asset classes rise, and even investment-grade bonds are susceptible to losses,” Acheson explains. Indeed, he notes that TDF bond portfolios declined alongside their stock portfolios, exacerbating losses in the recent meltdown.
Comparing Results
Acheson takes a deeper dive in looking at the variation in outcomes for near-retirees by comparing outcomes based on TDF asset-allocation approaches, including those focused on longevity risk versus market risk. One observation is that strategies focused on longevity risk has led to “long-term gain but near-term pain.”
For example, T. Rowe Price minimizes longevity risk via a heavy equity weighting in its Retirement series by targeting 55% in equities at retirement, versus 43% for the norm. The firm’s bond portfolio also courted more risk than most in the recent sell-off, contributing an estimated 3% loss in the 2020 fund. According to Acheson, that led to one of the industry’s worst outcomes for near-retirees during the drawdown, when its 2020 fund declined nearly 23%, lagging other target-date indexes by about 4 to 5 percentage points.
As of March 20, that largely wiped out the fund’s excess returns it had earned over the past five years, but the fund’s higher risk profile has paid off over the long term, he notes. Since the market bottomed on March 9, 2009, through March 20, 2020, it gained 192%, outpacing all its competitors, Acheson observes.
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Fidelity’s Freedom Funds also emphasizes longevity risk, but to a lesser degree. It’s above-average targeted equity stake of 52% at retirement contributed to its 2020 fund’s below-average 19.2% loss during the coronavirus sell-off. Investors in its 2020 fund have reaped the benefits of an overweight stake in equities during the past five years, but when stocks neared their trough this year, the 2020 fund’s one- and three-year returns came up short, Acheson observes. He notes, however, that the series remains a strong option.
Meanwhile, balanced approaches to risk management appears to have contained losses. Vanguard’s 2020 fund targets a 50% weighting in stocks at retirement, which largely drove its 18.6% decline in the drawdown. However, its conservative bond portfolio, which lost about 1% in the sell-off, lessens its risk profile, he notes.
JPMorgan’s SmartRetirement series takes less equity risk than the average peer for near retirees, targeting 33% in stocks at retirement. Its bond portfolio, which includes high-yield bonds, emerging-markets debt and bank loans, courts more risk than most, leading to an overall moderate risk profile. Acheson notes that the 2020 fund’s bond sleeve lost about 4% in the drawdown. Still, he notes that with a 17% loss, the 2020 fund held up modestly better than peers and target-date indexes.
BlackRock LifePath Index has the industry’s most aggressive equity glide path for young investors, but the series de-risks at a faster pace than most, ending with a below-average equity weighting of 40% at retirement, Acheson explains. As such, investors retiring in 2020 lost 15.3% during that period, meaningfully outpacing relevant target-date indexes and landing in the peer group’s top quintile.
American Funds’ 2020 fund, meanwhile, pulled off an “impressive feat,” according to Acheson. Despite an above-average 46% equity weighting, it lost 16.4% amidst the sell-off—while that’s still painful, he notes that it’s better than about 70% of peers. “The series’ bias toward giant caps with strong fundamentals, safe bond portfolios, and large cash balances held by its underlying funds offset its overweighting in stocks,” he observes.
Finally, John Hancock’s Multi-Index Preservation has the most conservative glide path among series that Morningstar covers. Acheson notes that that positioning helped this series’ 2020 fund outperform about 90% of rivals and both target-date indexes amidst the sell-off, when it declined 13.4%. He further observes, however, that the series’ overly conservative stance has weighed on returns over time.
