Balanced or Target Date: Two Good Choices

he Pension Protection Act of 2006 sets forth three options for QDIAs (Qualified Default Investment Alternative). They include target date (or life cycle) funds, balanced funds, and managed accounts. In all likelihood, target date funds will become the dominant auto-enrollment default option in tax deferred retirement plans. Nevertheless, balanced funds will also be selected by many investors. Therefore, this study evaluates the historical performance of a balanced fund approach and a target date allocation model using data from the past 48 years.

Balanced Funds

The classic balanced asset allocation is approximately 60% equities and 40% fixed income. This is the allocation of many balanced mutual funds, such as Dodge & Cox Balanced, T. Rowe Price Balanced, Vanguard Wellington, Fidelity Puritan, and many others. In fact, as of year-end 2007 there were over 130 distinct balanced funds (within the sub-category of "Moderate Allocation") in the Morningstar Principia database with total assets of nearly $350 billion. The typical allocation among the four components in a 60/40 balanced fund as of late 2007 was about 50% US equity (predominately large cap), 10% non-US equity, 30% bonds, and 10% cash. These allocations remain constant over time.

Target Date Funds

As of year-end 2007, the average 2040 target date fund had approximately a 90% equity/10% fixed income portfolio. The equity allocation was divided among US equity and non-US equity and fixed income was sub-divided among bonds and cash-both according to the average allocations among existing target date funds. The average 2030 target fund an 80/20 portfolio, the average 2020 fund had roughly a 65/35 allocation, the average 2010 fund had a 50/50 allocation. The average current or "Today" fund had a 40/60 allocation. Using these generalized allocations as guidelines, a hypothetical target date asset allocation model (or "glidepath") was constructed for the 48-year period of this analysis. The allocations through time in the target date fund's four core assets (US large equity, non-US equity, bonds, cash) are illustrated in "Four Glidepaths".

The Common Components

The annual returns of the four core components of balanced funds and target funds are shown in "48 Years". The components include US equity, non-US equity, bonds, and cash. The raw data source is Morningstar/Ibbotson Associates. The annual performance figures for large US equities is represented by the S&P 500 Index, while the performance of non-US equities is represented by the annual returns of Scudder International from 1960-1969 and the MSCI EAFE Index from 1970-2007. US Intermediate Term Bonds are represented by Ibbotson's own index, which is very similar to the Lehman Brothers US Government Intermediate Index. Finally, US cash is represented by the Ibbotson SBBI 30-day US Treasury Bills Index.

A summary of the performance results over the 48-year period from 1960-2007 is presented in "The Scorecard". The annualized return of the 60/40 balanced fund was 9.26% compared to 9.59% in the target date fund. The downside protection of the target date fund was somewhat better than the balanced fund as shown by the smaller "Worst One-Year $ Loss". However, both the target date fund and the balanced fund had dramatically better downside resistance (as measured by "worst one-year $ loss") than either of the equity components by themselves (US Equity and Non-US Equity).

For example, a portfolio solely invested in large US stocks had a worst one-year loss of over $177,000, whereas a sole investment in non-US stocks lost nearly $108,000 in one year. By comparison, the worst one-year loss for the target fund was $33,426 and $41,030 for the balanced fund. Not surprisingly, these worst case one-year losses took place in 2002. The loss in the balanced fund was larger because-unlike a target date fund-it does not use a glidepath to trim equity exposure over time as the account balance is growing.

A key observation here is that even though the 100% equity account and the target date fund had a similar worst case one-year % losses over this 48-year period (-26.47% for all equity versus -22.36% for target date fund) the worst-case loss as measured in dollars was vastly worse for the 100% US large stock account ($177,853 loss versus $33,426 loss). In the latter stages of an accumulation portfolio-when the account balance is large-a material percentage loss translates into a very large dollar loss. For that reason, it is important to progressively protect the assets in an accumulation portfolio to insulate it from large dollar losses. This is precisely the logic driving the design of target date funds. A balanced fund starts this protection process earlier, and some may argue that it is protective too early and then does not become protective enough in the final years prior to retirement.

As would be expected, bonds and cash are not subject to large losses. The price for downside protection in bonds and cash is, obviously, the lack of capital growth. A $10,000 investment solely in bonds in 1960 grew to about $275,000 by the end of 2007. A 100% investment in cash had an ending account value was just over $132,000. In the balanced fund, the ending value of a $10,000 investment was just over $700,000, and in a target date fund the ending balance of a $10,000 investment was $810,604. A $10,000 investment solely in the S&P 500 grew to $1,146,399 (before taxes and inflation).

But, growth comes at a price. US Equity by itself experienced a negative annualized return in five separate 5-year periods over this 48-year span. Non-US stock had four 5-year periods with a negative annualized return. Bonds and cash by themselves had no 5-year periods with a negative return. (The returns in this analysis have not been adjusted for inflation). The composite target date fund in this study had one five-year period with a negative return. It was the five-year period ending in 1974 and its 5-year annualized return was -.33%. The balanced fund never had any 5-year periods with a negative return. In fact, the lowest 5-year annualized return for the balanced fund was 1.85%, while its average 5-year rolling return was 9.54% compared to 9.98% for the target date fund.

The trade-off between risk and return for each separate asset as well as the target fund and the balanced fund is shown in "Two Winners". Cash and bonds are nearest the southwest quadrant indicating lower volatility of return and lower return. In or near the northeast quadrant is US equity and non-US equity-higher returns with higher volatility of return. Situated nearest the coveted northwest corner is the balanced fund and the target date fund. Their location in the graph represents an attractive blend of risk and return, with the target fund demonstrating slightly higher risk and return than a balanced fund.

How important is this kind of compromise? Refer back to the table "48 Years" and look at the performance of each separate asset during the period from 2000-2002. Isolated investments in either US equity or non-US equity got hammered. Over that ugly three year period the S&P 500 lost 38% (cumulative 3-year loss) and non-US stocks lost a cumulative total of 43%. Bonds did great, gaining 37% cumulatively over the 3-year period, while cash increased by a total of 12%. The 60/40 balanced fund got dinged, but came through the 3-year period losing a cumulative total of 14.9%. The target date fund lost a cumulative total of "only" 11.3%-which is another reminder of the virtue of a descending equity glidepath.

Both QDIA default options-balanced funds and target date funds-will generally deliver middle-of-the-road returns each year compared to the performance of the core individual assets in an accumulation portfolio. That is, better performance than bonds or cash in most years, and lower returns than one or both of the individual equity components in most years. As such, a balanced fund and/or a target fund may appear to be a relatively bland approach to investing. But, bland is good. Investing is not supposed to be exciting. Scams are exciting-that's why people get sucked into them.

A fundamental intention of the Pension Protection Act is to avoid scenarios in which a 28-year old worker chooses a money market fund as his/her primary 401(k) holding. Cash won't get the job done. Countless workers will be advantaged by being "defaulted" into a balanced fund and/or a target date fund. Of the two, target date funds are likely the better choice simply because, unlike balanced funds, they have a glidepath that throttles down the risk as they approach their retirement landing.

Four Glidepaths

48 Years (Annual % Returns)

Year	US Equity	Non-US Equity	Intermediate Term US Government Bond	US Cash	Average Target Date Fund  Allocation*   (%US Equity / % Non-US Equity / % Bonds / % Cash)	Target Date Fund	60/40 Balanced Portfolio   50% US Equity 10% Non-US Eq 30% Bonds      10% Cash
1960	0.47	(4.37)	11.76	2.66	65 / 25 / 7 / 3	0.12	3.59
1961	26.89	18.06	1.85	2.13	65 / 25 / 7 / 3	22.19	16.02
1962	(8.73)	(10.33)	5.56	2.73	65 / 25 / 7 / 3	(7.79)	(3.46)
1963	22.80	9.48	1.64	3.12	65 / 25 / 7 / 3	17.40	13.15
1964	16.48	12.86	4.04	3.54	65 / 25 / 7 / 3	14.32	11.09
1965	12.45	(0.07)	1.02	3.93	65 / 25 / 7 / 3	8.26	6.92
1966	(10.06)	(11.46)	4.69	4.76	65 / 25 / 7 / 3	(8.93)	(4.29)
1967	23.98	22.70	1.01	4.21	65 / 25 / 7 / 3	21.46	14.98
1968	11.06	21.76	4.54	5.21	65 / 25 / 7 / 3	13.10	9.59
1969	(8.50)	5.67	(0.74)	6.58	65 / 25 / 7 / 3	(3.96)	(3.25)
1970	4.01	(11.66)	16.86	6.52	65 / 25 / 7 / 3	1.07	6.55
1971	14.31	29.59	8.72	4.39	65 / 25 / 7 / 3	17.44	13.17
1972	18.98	36.35	5.16	3.84	65 / 25 / 7 / 3	21.90	15.06
1973	(14.66)	(14.92)	4.61	6.93	65 / 25 / 7 / 3	(12.73)	(6.75)
1974	(26.47)	(23.16)	5.69	8.00	65 / 25 / 7 / 3	(22.36)	(13.04)
1975	37.20	35.39	7.83	5.80	65 / 25 / 8 / 3	33.46	25.07
1976	23.84	2.54	12.87	5.08	64 / 24 / 8 / 4	17.13	16.54
1977	(7.18)	18.06	1.41	5.12	64 / 24 / 9 / 4	0.01	(0.85)
1978	6.56	32.62	3.49	7.18	63 / 23 / 10 / 4	12.28	8.31
1979	18.44	4.75	4.09	10.38	63 / 23 / 11 / 5	13.49	11.96
1980	32.42	22.58	3.91	11.24	62 / 22 / 11 / 5	26.05	20.77
1981	(4.91)	(2.28)	9.45	14.71	62 / 22 / 12 / 5	(1.64)	1.62
1982	21.41	(1.86)	29.10	10.54	61 / 21 / 13 / 5	16.91	20.30
1983	22.51	23.69	7.41	8.80	61 / 21 / 13 / 6	19.96	16.73
1984	6.27	7.38	14.02	9.85