Getting the right mix of assets in your investment portfolio is typically the key to reaching your retirement goals. The 60/40 portfolio, which divides assets between equities and fixed income, is the classic approach for people approaching retirement looking to hedge risk.
But you might have heard lately that some retirement experts and market gurus agree the assumptions underpinning this traditional method of hedging risk from equities simply don’t work anymore. The gist of this idea is that bonds aren’t providing the risk-mitigation and diversification benefits investors expect.
If this is true, target date funds might need some adjustments — as they run off many of the same assumptions that guide a 60/40 portfolio.
Target date funds, popular investments inside 401(k)s are mutual funds designed for retirement planning that start off heavily weighted toward stocks. Gradually, they transition into the safety of bonds as people approach retirement following a “glide path.”
Fidelity says that they occasionally tweak the portfolios, altering the stock-bond mix but also the types of bonds involved. REUTERS/Brian Snyder
Take Vanguard’s popular 2050 fund, for people born between 1983 and 1987 and who expect to retire around 2050. Currently, it has a 10% allocation to bonds and 90% in stocks, according to the prospectus (it started that way too). For people 10 years away from retirement, it’s 75% in stocks and 25% in bonds. Generally, a target date fund’s “glide path” will hit the 60 stocks/40 bonds mark close to the projected retirement date and then go bond-heavy after retirement.
In the short term, equities are typically more volatile, with more risk and more potential for reward. Bonds traditionally have less upside, but also less volatility – which is why they’re favored for those close to or in retirement, when there’s higher sensitivity to market crashes.
But if a target date fund’s composition is based on assumptions and estimates that are in question, what does it take for the fund to alter its glide path?
Why is the 60/40 is in question? The role of bonds has changed.
Today, bonds aren’t behaving the way they’re supposed to, and many market analysts have discussed how their role has changed — potentially forever. They’ve become less predictable and return less, which has undermined the popular notion of holding 60% of assets in stocks and 40% in bonds.
That allocation doesn’t make sense in 2020, Bank of America Merrill Lynch’s head of the research investment committee, Jared Woodard, wrote in October.
“The relationship between bond and equity returns is one of the fundamental building blocks of modern financial portfolios,” Woodard wrote in a note to clients. “It drives conventional ideas about benchmarks such as a 60% allocation to equities and 40% allocation to fixed income.”
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The abandonment of this “conventional idea” has essentially become somewhat of a consensus. In JPMorgan Chase’s 2020 Long Term Capital Assumptions, published this month, analysts noted that returns from a 60/40 U.S. stock-bond portfolio are expected to be down to 5.4%, 10 basis points over the next decade. The report also noted that “policymakers may have boxed themselves into a low rate world” and that explored the possibility that rates might be “lower for...ever.”
“Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” the summary notes. “The days of simply insulating exposure to risky assets with an allocation to bonds are over.”
What is needed, JPMorgan says, is “in equal measure, greater flexibility in portfolio strategy and greater precision in executing that strategy.”
When target date funds react
Target date funds concern themselves with the delicate balance between equities and fixed-income products, but with long-term outlooks.
Finola McGuire Foley, portfolio manager for Fidelity’s Freedom Funds and other target date strategies, told Yahoo Finance there are many factors that would affect when and how a target date fund would change its glide path.
In 2018, the managers did decide to make a change, reducing equity holdings for some funds by 5%.
“We have flexibility for our active funds,” Foley said. “We do have the flexibility to shift the stock-bond equity mix.”
While portfolio managers continuously evaluate glide paths, “it may not always lead to an update,” she said.
Potential changes are also not limited to stock/bond allocations. In 2018, Foley and her team decided to change the bond mix, diversifying many of the target date funds with more long-term treasuries and adding TIPS (Treasury Inflation Protected Securities).
But it’s not just the market and outlook that affects how the portfolio managers think: They look at the other side of the fund, at the clients.
“We’re looking at trends on how people are saving, what age people are retiring,” said Foley.
Major changes are rare and don’t happen often
Scott Donaldson, a senior investment strategist at Vanguard, said it would generally take a lot to change a target date fund’s glide path in a major way — and pointed to similar trends about people’s behavior as potential large reasons.
Donaldson said it would only change if “we believe something across the financial markets has changed structurally and its inherent risk/reward is significantly different going forward than it has been in the past.”
So what would be major enough to warrant adjustment in the glide path? New regulations that increase savings rates; changes in Social Security, a big jump in life expectancy. Essentially, changes that are more social and political than market-related.
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Ethan Wolff-Mann is a writer at Yahoo Finance focusing on consumer issues, personal finance, retail, airlines, and more. Follow him on Twitter @ewolffmann.