Hitting the Mark with Target Date Portfolios

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 Morgan Stanley Pathway Funds and Morgan Stanley Pathway 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, helping limit the chance a market shock wipes out a substantial portion of your portfolio as you're getting ready to cash out. If your projected retirement date changes, you can move your funds into a different target-date fund or choose a different investment strategy.

Different Types of Portfolios

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 a portfolio for those nearing retirement might hold 40% in stocks.

Rather than making the adjustments every year manually, and perhaps making some prudent (or imprudent) tweaks, a target date portfolio changes 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 for your whole life cycle, target date portfolio will adjust automatically on your behalf," says Garcia.

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 index funds, or a combination of both.

Target date portfolios 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). Target-date funds are popular options within workplace retirement plans, such as 401(k)s, but you can also invest in a target-date fund privately.

Managing Sequence of Returns Risk

One of the main benefits of a target date portfolio may be how it handles one of the biggest risks to a retirement portfolio, the 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, there's 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 may be considerably less affected 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 analysis from the Morgan Stanley Global Investment Committee. If the committee forecasts a rough upcoming two to three years, the target date portfolio 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.