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The Global Tilt in Target Date Funds

Target date portfolios are taking a more global stance: What has changed and considerations for plan sponsors

Target date funds (TDFs) have quickly become a favorite default option within retirement plans. While the overall split among stocks and bonds within a TDF series, commonly referred to as the glide path, is a primary driver of results and therefore participant outcomes, what those asset classes are composed of can also impact results and is worthy of consideration. As a number of TDF providers have announced changes to their TDFs’ international stock and bond exposures, it is important for plan sponsors to understand the implications of those changes and how their plan’s TDFs may be affected. In addition, TDF providers can use different tools when implementing these changes, from strategic shifts to tactical overlays to currency hedging, adding another layer to consider when evaluating the product.

Becoming More Global

Since 2007, the average international stock exposure across TDFs has moderately increased from roughly 18% to 22% of assets. On the bond side, the average international exposure has grown from less than 1% to 4% of assets.

Changes in Average TDF Allocation to International Securities

Those numbers are likely to grow further this year. For example, Vanguard, the largest mutual fund TDF provider by assets, announced earlier this year that it would increase its international stock stake from 30% to 40% of stock assets throughout 2015. In addition, after introducing international bonds to the portfolio for the first time in mid-2013, the firm is also boosting the international sleeve of its TDFs’ bond assets from 20% to 30%. American Century, PIMCO, Prudential, and Schwab are among other providers also adding international bonds or increasing their international stock exposure.

There are several reasons providers are continuing to rethink the global exposures of their TDFs. One is to reduce the home country bias in their portfolios. While no provider has gone so far as to match the global market’s roughly 50% U.S./50% international stock split and 40% U.S./60% international bond split, over time the average TDFs’ allocation has inched closer to that of the global market portfolio. For some providers, the strength of the U.S. stock and bond markets over the past several years is reason to think international markets may provide better opportunities going forward. In addition, at least according to the team at Vanguard[1], the cost to invest in international markets has become less expensive.

Variations in Exposure

Not all TDF providers have moved at the same pace, and there is still wide variation in the range of international exposures across TDFs, as depicted below in Figures 2 and 3. No provider eschews international stocks completely, although there are still a few that do not utilize international bonds, or at least do not include a dedicated international bond strategy.

In addition to the range of international exposures among different providers, there is also variation along individual glide paths. For example, American Century decreases the international exposure of its TDFs’ stock sleeve as retirement date approaches, while other providers, including TIAA-CREF, keep their TDFs’ international stock exposure at the same proportion of the stock sleeve throughout the glide path.

Glide Path Allocation to International Stocks and Bonds

Additional Considerations

The data above depicts the most recent actual allocations to international stocks and international bonds across TDFs during the years leading up to the retirement date. These allocations may differ from what TDF providers state as the strategic, or neutral, allocation of their portfolios. One reason for a potential discrepancy is that some U.S. stock and U.S. bond funds, while typically considered to be part of the TDFs’ exposure to U.S. markets, can also include exposure to international securities. For example, the longer-dated funds in MFS’ TDF series have a strategic allocation of 28% to international stocks. In practice, the funds have a larger allocation to international stocks, as several of the underlying domestic stock funds have some exposure to international stocks as well.

In addition, while most of the increases in TDFs’ international stock and bond exposures are strategic in nature, reflecting providers’ desire to have more global exposure in their products, some providers also have the ability to tactically allocate to international securities. This is done by over or underweighting select sub-asset classes to take advantage of shorter-term opportunities providers see in the market. For example, the team at T. Rowe Price utilizes tactical allocation, and has recently been favoring international stocks over U.S. stocks based on where the team sees more attractive valuations. Plan sponsors should note the degree to which their plan’s TDFs may tilt between sub-asset classes, and be comfortable with the leeway used by their provider. While it is difficult to consistently time such market shifts correctly, most providers keep relatively tight reins on the amount of assets they can shift from one sub-asset class to another, most often less than 10% of the exposure.

More so, investing internationally carries an additional risk from exposure to currency fluctuations, and plan sponsors should be cognizant of how their provider handles this exposure. For the most part, this function is managed by the underlying managers of each individual stock or bond strategy. Most stock managers do not hedge all of their international currency exposure, as research has shown currency hedging generally does not materially reduce volatility or increase returns over the long term for stocks. For international bond exposure, however, most providers do hedge all or the majority of the currency exposure. Research from Capital Group[2] has shown that international bonds have added unwanted volatility stemming from currency exposure, which makes hedging more compelling, especially when bonds are viewed as the ballast in a diversified portfolio. Vanguard has also elected to fully hedge the currency exposure within its relatively new international bond fund, citing benefits from hedging that outweigh the costs.[3]

Conclusion

While the overall asset allocation of TDFs will continue to have the largest impact on results, it is important for plan sponsors to understand and be comfortable with the nuances of the sub-asset class exposures within their selected TDFs. PEI welcomes the continued trend to increase international exposure within TDFs, as the diversification from having a global portfolio can reduce volatility and boost risk-adjusted results over the long term. As TDF providers in general take a more global stance, an evaluation of the international allocations and implementation tools used by TDF providers continues to be an important part of a prudent due diligence process.


[1] “Vanguard enhances diversification for target date funds and other all-in-one funds,” Vanguard, February 2015.
[2] “Dollar’s Rise is a Double (H)edged Sword: The Case for Selective Hedging,” Capital Group, May 2015.
[3] “Global fixed income: Considerations for U.S. investors,” Vanguard, February 2014.