5 Portfolio Lessons From Target-Date Funds

The catalyst for target-date funds' ascendance was jump-started by the Pension Protection Act of 2006, which made the funds a safe-harbor default options for employer-sponsored defined-contribution retirement plans. In layperson’s terms, the legislation meant that companies could begin auto-enrolling new employees in those investments without fear of lawsuits.

Many plan sponsors did so, vaulting target-date funds from a relatively minor sideline business for most firms to a $1 trillion-plus force in the retirement space and a must-have on the platform of most mutual fund firms. In its most recent “How America Saves” study, Vanguard (which has more target-date assets than any other firm) reports that 97% of its participants are in plans offering target-date funds, while 77% use a target-date fund as part of their retirement plan, and 52% are wholly invested in a single target-date investment. In 2006, less than 10% of Vanguard participants owned only a target-date fund.

Target-date funds have certainly gotten a boost from that legislation, but they are also one of the industry’s better innovations from an investment perspective. I’ve been impressed by target-date funds from when I first began researching them in 2009 as part of the team at Morningstar that launched our original target-date series ratings and reports. The funds manage to roll up a highly sophisticated investment process into a product that’s extremely easy to use for the average investor. For that reason, I think target-date funds make perfect sense for many investors, even outside of their 401(k)s. My wife’s IRA is invested entirely in a target-date fund.

The point of this column, however, is not to persuade you to invest in a target-date fund. Rather, I want to distill what I think are some of the most effective aspects of target-date products, indeed part of the reason for their success, and suggest ways that those of us who manage our own portfolios might adapt those techniques to our own investment practices. Target-date series at the largest firms have been developed by asset-allocation teams with extensive resources and vast experience in retirement research, capital-market forecasting, asset allocation, and manager selection, and there’s no reason you can’t benefit from their insights even if you aren’t investing directly in their products.

This list is by no means comprehensive, but I think it highlights some of the most important and tangible lessons investors can take away from target-date funds.

Lesson 1: Invest With Your Goals in Mind This point may seem obvious, but the reality is that most of us accumulate investments in a haphazard manner, without much of a bigger-picture viewpoint on how our allocations should look from the 3,000-foot level. Target-date fund managers flip that equation on its head: They begin by asking the biggest and thorniest questions--What percentage of people's working income will they need to generate from a nest egg in retirement, How long will it need to last, and How best should they invest that money during their working years to get to that point?--in order to generate the asset allocations used across the various vintages of a target-date series (what's called, in industry parlance, a glide path). Certain perspectives will inevitably get baked into these processes, accounting for the different glide paths among target-date providers; one provider may believe it's more important to emphasize safety of capital near an investor's retirement date, for example, while another may believe growing the nest egg retains higher importance at that point.

You may not have the resources to run 10,000 Monte Carlo simulations on your portfolio, but as an individual investor, you have an advantage over the target-date firms. While they must create allocations that will potentially work for hundreds of thousands or millions of participants, you have an investor base of one. You know your financial situation and future prospects, your comfort with risk, and the specific financial goals for which you need to save. This doesn't mean you have to get things 100% accurate; there's as much art as science to asset allocation. But if you start by asking the right questions of your financial goals, risk capacity, and so on, you'll get your portfolio a large part of the way there. As Christine Benz has suggested, looking at the asset allocations offered by a variety of target-date providers and then customizing to your own personal factors can serve as an excellent guide.

Lesson 2: Invest in Equities Early and Often This comes as something of a corollary to lesson No. 1. Most target-date managers have reached the conclusion that the best way to help their investors overcome the retirement-savings challenge is to allocate heavily to stocks when they are young. The average target-date series holds 90% in stocks in their longest-date funds (those intended for investors just starting out in the workplace), with some investing up to 100%. Even funds intended for investors 15 years away from retirement tend to tilt heavily toward equities: The industry average is 72% in stocks, while firms with equity-heavy glide paths like T. Rowe Price invest as much as 80% in stocks. This makes perfect sense, as equities offer meaningfully higher long-term return prospects than bonds, and though they can suffer pronounced drawdowns, the long time horizon of most target-date investors means they should be able to ride out the dips.

Self-directed investors should adopt a similar mindset. Once you’ve gone through the exercise of developing an asset-allocation perspective, try to maximize your exposure to equities (within the constraints of your risk tolerance, risk capacity, goals, and needs, of course). This holds doubly true if you are more than 20 years from retirement. The road may be bumpy at times, though, and investors who may need to draw on their nest egg nearer-term should keep in mind that we have witnessed a historic run for the stock market over the past decade, one that is not likely to be repeated.

Lesson 3: Adjust Your Allocation Over Time One of the niftier aspects of target-date funds is that they take over many of the laborious and technically challenging tasks associated with portfolio management. Two in particular are rebalancing and rolling down the glide path. Rebalancing is important because over time, as one subasset class does well while another lags, your initial allocations will become skewed. Target-date funds typically rebalance to their target weights on a monthly basis, if not more frequently, relying on both inflows from new investors and sophisticated trading technologies to ease the process. For investors who have a lot of funds, this can be a challenging exercise, so it's probably best to limit the review to once a year, and to set relatively generous thresholds for when you will restore allocations to their target levels (perhaps when they hit a 10% deviation or more). Christine Benz offers some smart tips on ways to think about rebalancing here.

Target-date funds also engage in an annual “rolldown” of the glide path, by which they incrementally shift the stock/bond balance in the portfolios so that investors move toward the appropriate allocation for their ages. For DIY investors, there would be little advantage (and probably some disadvantage ) to make such a small shift on an annual basis. Still, it’s important to recognize that one’s appropriate asset allocation will differ from age 20 to 50, from 50 to 70, and so on, so at least every few years we should evaluate whether that initial allocation plan still makes sense, or whether it’s time to shift a chunk from stocks to bonds.

Lesson 4: Diversify Yes, diversification has been a tough sell in recent years. Most investors would have been better off pouring all their assets into U.S. large-cap growth stocks. But target-date managers aren't backing off from diversification, and neither should you. Indeed, one of the biggest selling points of target-date funds is their ready access to multiple asset classes: everything from international bonds and emerging-market equities to real estate, TIPS, high-yield bonds, and often more specialized asset classes. The average 2060 target-date fund has around 30% of its equity sleeve in non-U.S. stocks. And while diversification can often feel painful in the short term, its long-term benefits are clear in both theory and practice. As I discussed in my initial column, you needn't chase down the rabbit hole of every asset class, but you should at least cover the basics.

Lesson 5: Stay the Course This last point gets at what may be the biggest benefit of target-date funds: their positive behavioral impact on investors. We can best view this from the funds' positive gap between their investor returns and total returns over 10-year periods, which Russ Kinnel details in his annual Mind the Gap report. Most fund categories evince a negative gap, reflecting the poor timing exhibited by investors when they buy and sell funds. Target-date funds, by contrast, produce on average higher investor returns than total returns, a result in part of consistently strong returns over the periods but also, as Russ has noted, "Target-date funds are easy for investors to use because performance swings are muted, and most investors buy in through 401(k) retirement plans with automated savings processes, which creates a disciplined track of continued savings." You could argue that some of this may be simple inertia (which may not be a bad thing), but much of it is inherent to the design of target-date funds. Even in 2008, there was minimal movement by investors to withdraw assets from target-dates.

We’d all do well to model the behavior that target-date funds have instilled in investors. Establishing a diversified investment plan and sticking with it, making regular contributions, and paying as little heed as possible to the noise of the markets around us, is likely to be a winning formula, whether we invest directly in a target-date fund or adopt its principles to our own portfolios.