Returns for 2020 Retirees During Coronavirus Selloff (Chart via Morningstar)

Target date funds performed pretty much in line with expectations amid the coronavirus bear market meltdown in March and they were certainly not immune from extreme selloffs, according to Leo Acheson, director of multi-asset ratings and global manager research at Morningstar.

Outcomes during the Feb. 20-March 20 period, however, varied significantly for near-retirees, highlighting the importance of investors knowing their specific target date fund’s risk profile, he pointed out Monday in an article on the firm’s website.

While the diversification benefits of TDFs “dissipated, that’s not abnormal during extreme sell-offs,” he pointed out.

Another key takeaway from his research was that TDFs “held up better during the coronavirus drawdown than they did during the global financial crisis, a sign of industry progress,” he said.

TDFs have grown in popularity in 401(k) plans, with assets passing $2 trillion as of Dec. 31, he noted. Their “highly diversified portfolios and systematic reduction in risk as retirement approaches also make them strong options for hands-off investors putting taxable money to work,” he pointed out.

However, the “sharp selloff caused by the global coronavirus pandemic served as a good reminder that, despite extreme diversification, not all target date funds are created equal,” he said. Therefore, he warned: “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.”

Investors who expected to retire this year and had 2020 TDFs lost more than 17% on average, while those expecting to retire in 40 years (with 2060 TDFs) lost 31%, which was a “minor improvement versus U.S. equities, which fell 33%, and global equities, which declined 32%,” he said.

TDFs have “captured more of the equity market’s downside than would be anticipated from their strategic equity weighting,” he pointed out, explaining:

“While seemingly counterintuitive, that aligns with expectations. During more-modest equity selloffs, 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. Indeed, target date fund bond portfolios declined alongside their stock portfolios, exacerbating losses in the recent meltdown.”

In comparison, during the global financial crisis, when U.S. equities tumbled 55% cumulatively from their October 2007 peak to their March 2009 bottom, investors planning to retire in 2010 on average lost 67% as much as U.S. stocks, he pointed out. Investors planning to retire in 2020 fared better during the COVID-19 sell-off, capturing on average 55% of the U.S. market’s 33% loss, he said.

Younger investors fared better during the coronavirus bear market also, he pointed out, noting that investors 30 years from retirement lost 92% as much as U.S. equities amid the COVID-19 sell-off, versus 98% during the global financial crisis.

The Near-Retirement Risk

TDF investors are the most at risk when they near retirement, as their account balances are likely nearing all-time highs and “these individuals will presumably soon forgo their salaries and rely on their savings,” Acheson said. Early-in-retirement losses may disrupt retirees’ plans, particularly when investors start making withdrawals, “locking in lower account values,” he noted.

The chart above shows returns for investors planning to retire in 2020 across some of the industry’s most prominent or unique target date series, he said, referring to American Funds Target Date Retirement, BlackRock LifePath Index, Fidelity Freedom, John Hancock Multi-Index Preservation, JPMorgan SmartRetirement, T. Rowe Price Retirement and Vanguard Target Retirement.

The chart also depicts the contribution of returns by each series’ equity, allocation, fixed income/cash and commodity underlying fund exposures using holdings as of Dec. 31. “Notably, each TDF’s fixed-income/cash portfolio lost money in the recent drawdown, declining anywhere from about 1% to 5%,” Acheson said.

Although concentrating on longevity risk has led to long-term gain, he noted that it has also resulted in near-term pain. For example, T. Rowe Price has long committed to minimizing longevity risk through a heavy equity weighting in its Retirement series, he pointed out, noting that firm targets 55% in equities at retirement, versus 43% for the norm.

Meanwhile, that firm’s bond portfolio also “courted more risk than most in the recent selloff, contributing an estimated 3% loss in the 2020 fund,” he said, adding: “That led to one of the industry’s worst outcomes for near-retirees during the drawdown, when its 2020 fund declined almost 23%, lagging relevant target date indexes shown in the table … 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.”

On the other hand, that fund’s higher risk profile “paid off over the long term — since the market bottomed on March 9, 2009, through March 20, 2020, it gained 192%, outpacing all its competitors.”

The More Balanced Approach

A more balanced approach to risk management, on the other hand, “contained losses” during the COVID-19 volatility, Acheson said. Vanguard’s 2020 fund, as an example, targets a 50% weighting in stocks at retirement, and that “largely drove its subpar 18.6% decline in the drawdown,” he said, but noted its conservative bond portfolio lost only about 1% in the selloff, lowering the fund’s risk profile.

JPMorgan’s SmartRetirement series, meanwhile, “takes meaningfully less equity risk than the average peer for near-retirees, targeting 33% in stocks at retirement,” he said. Its “bond sleeve lost about 4% in the drawdown,” but with a 17% loss, the 2020 fund “held up modestly better than peers and target date indexes,” he said.

John Hancock’s TDF offers the “most conservative glide path” among the series Morningstar covers, he said. Its positioning helped it “outperform about 90% of rivals and both target date indexes amidst the selloff, when it declined 13.4%,” he said. However, he said that firm’s series’ “overly conservative stance has weighed on returns over time.”

— Related on ThinkAdvisor: