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Best Types of Mutual Funds for IRA and 401K Portfolios

by

Jack Piazza
Sensible Investment Strategies

For most investors, 401k and IRA investments comprise a substantial portion of their total portfolios. When investors experience substantial losses, it is perfectly natural for investors to question the strategies, asset allocation and mutual fund selections of their retirement plans. Let's first summarize the market performance in 2008, examine various asset allocation strategies, review investor concerns and address one of the key benefits of traditional retirement plans.

The overwhelming majority of  investors experienced significant losses in their 401k and IRA portfolios in 2008. According to Morningstar data, every category average in both domestic stocks and foreign stocks, including sector funds, produced a negative return for 2008 -- the worst year for the market since the Great Depression. Even the majority of bond fund categories had negative returns in 2008 -- only government bond categories (Treasuries and Government Mortgage) generated positive returns. The following table depicts 2008 returns for major domestic and international equity indices:

 S&P 500 - large cap  -37.88%
 S&P 400 - mid cap  -37.21%
 Russell 2000 - small cap   -33.79%
 MSCI EAFE - international  -43.56%
 Dow Jones Moderate - balanced  -25.18%

As a result of these losses in 2008, every investor has asked at least one or more of the following questions:  Do I have (1) the confidence in the market to continue adding to my retirement portfolio, (2) the proper asset allocation in my retirement portfolio and (3) my appropriate tolerance for risk? To reflect on these questions, a review of past market performance is necessary to gauge performance over long time periods and to hopefully alleviate concerns for most investors. The following information illustrates returns for different asset allocations, using rolling five-year periods from 1926-2008 and using the S&P 500 index for stocks and long-term United States government bonds (source: Ibbotson Associates).

Asset Allocation

 

 Annualized Five-Year Returns
    Average     Best      Worst

 

  100% Stocks        10%       29%     -12%
    90% Stocks/10% Bonds          9%       27%     -10%
    70% Stocks/30% Bonds          9%       23%       -6%
    50% Stocks/50% Bonds          8%       21%       -3%
    30% Stocks/70% Bonds          7%       21%        0%

These long-term rolling five-year statistics over an eighty-three year period illustrate remarkable differences in risk and reward. A comparison of these figures show the 70% stock/30% bond allocation has only an annualized return of 10% less than the 100% stock allocation (9% verses 10%) with significant less volatility over the long-term. In the 30% stock/70% bond allocation -- a highly recommended allocation for those in retirement -- no negative return occurs in this long-term rolling five-year scenario. In addition, the other allocations also reveal that volatility decreases when stock allocation percentages decrease. Note: if small-cap stocks and/or foreign stocks were even modestly included in these examples, the result would undoubtedly show both greater reward potential and significant increases in volatility.

How do these statistics relate to the concerns of investors? First, all of these asset allocations show positive returns over the long-term, which should instill investor confidence in the market. Second, many investors should reevaluate their asset allocation percentages between stock and bond funds, asking what degree of volatility (risk tolerance) would be acceptable for potential return. Finally, investors should apply this information to their IRA and 401k investments, taking advantage of the two most important features of these retirement programs (described below).

 IRA and 401k Benefits

In traditional IRA and 401K plans, two main benefits exist for investors: (1) deductions from gross income for contributions and (2) tax-deferred accumulation of earnings. Everyone who contributes to an IRA and/or a 401k is aware of the front-end deduction benefit; however, most investors, in my opinion, do not properly assess the effect of tax-deferred accumulation of reinvested earnings. Simply stated, reinvested earnings consist of bond interest, stock dividends and capital gain distributions; all of these distributions are exempt from taxes until withdrawals, at which time 100% of the amounts withdrawn are taxed at ordinary income rates.

Note: a Roth IRA (where all qualified withdrawals are tax-free instead of tax-deferred) will have the same following strategies as a traditional IRA.

 IRA and 401k Strategies

The KEY to investment success in retirement portfolios is taking advantage of the tax-deferred/tax-free compounding of reinvested distributions by systematically increasing the number of shares in mutual funds. By focusing on mutual funds which emphasize distributions, investors have a reasonable opportunity to generate positive return potential with comparatively lower volatility over the long-term. For example, reinvested distributions in the above 70% stock/30% bond allocation earn compounded bond interest and stock dividends that add shares with comparatively low to average volatility; capital gain distributions, although not as predictable as interest and dividends, also contribute to increased shares. As share accumulation increases, the greater the compounding effect reinvested distributions have on increasing asset value.

Only two ways exist to increase the number of shares in retirement accounts: (1) contributions (including employer matches) and (2) reinvested distributions. While obviously desirable, price appreciation increases portfolio value, but by itself does not add to the number of shares - unless any holdings in the particular mutual fund are sold with the subsequent profits (i.e., capital gain distribution) buying additional shares in the same fund. Yet many investors mistakenly select aggressive growth funds as the majority for their portfolio; when market downturns occur, they become disenchanted and often end up with the same number of original shares, but with a possible decrease in asset value. However, it's acceptable to have a small portion (15% or less, preferably less) in aggressive funds, provided one can deal with the increased risk. A good rule to remember: core holdings in retirement plans should always emphasize distributions (interest, dividends and capital gains) to help control volatility and to increase the number of shares in the portfolio.

 Best Fund Categories

In IRA and 401k plans, fund categories that emphasize distributions should be core holdings, including:

  • balanced funds, moderate allocation -- usually 60-70% large value & 30-40% government and corporate bonds

  • balanced funds, conservative allocation -- usually 30-35% large value & 65-70% government and corporate bonds

  • target-date funds -- broad-diversified fund of funds that tie allocation to various retirement dates (see Target Retirement Funds for details)

  • fund of funds (stock and/or bond) -- similar to makeup of target-date funds, except allocation is determined by general market conditions

  • equity income/dividend growth -- large value funds that put emphasis on stock dividends from established companies

  • corporate and government bond -- short, intermediate and long-term corporate, treasuries and government mortgage bond funds

  • multi-sector bond -- funds that invest in a broad-based spectrum of bonds, including small portions of high-yield and emerging markets

Investors can choose among the following non-core holdings to enhance returns in retirement plans, assuming the additional volatility is acceptable:

  • foreign large value -- funds that invest in established international markets

  • large growth -- large-cap funds that invest in above-average price/earnings ratio stocks; income is secondary

  • mid value -- mid-cap funds that offer low income with price appreciation potential

  • small value -- small-cap funds that invest in low price/earnings ratio stocks

  • high-yield bond -- funds that invest in bonds with  high income with corresponding volatility

 Recommended IRA and 401k Allocations

General stock/bond allocations percentages should be determined before specific fund selection. The following allocations provide a reasonable balance between reward and risk, underscoring the tax-deferred compounding of reinvested distributions and depending upon number of years left until retirement:

  • 70% stock/30% bond -- 10+ years until retirement: asset accumulation with growth and income

  • 50% stock/50% bond -- less than 10 years until retirement: a shift to increased income with less volatility

  • 30% stock/70% bond -- for retirees: capital preservation and income are priorities with growth secondary

For the above allocations, risk tolerance can be aggressive, moderate or conservative (see The Role of Risk in Mutual Fund Portfolios for further information). However, if one is using only one fund in a retirement plan, then the balanced fund, moderate allocation category is obviously appropriate for a moderate risk tolerance; the balanced fund, conservative allocation category is appropriate for a conservative risk tolerance; target-date retirement funds tend to be more appropriate for a moderate to slightly aggressive risk tolerance, due to their overall higher stock allocations.

Using two active-managed fund of fund categories in the above allocations can offer investors (1) broad diversification, (2) control for maintaining the allocation percentages and (3) maximum utilization of total distribution potential (interest, dividend and capital gains). For example, two no-load fund of funds, T. Rowe Price Spectrum Growth (prsgx) for stock, and T. Rowe Price Spectrum Income (rpsix) for bonds, can be used  for any of the above allocations. Periodic rebalancing to maintain the allocation percentages is easily accomplished by rebalancing (see Rebalancing Your Portfolio for details).

 Related Questions

When using the recommending one of the asset allocation models, how can risk tolerance be increased or decreased? One method is to add a desired fund which would slightly change the overall allocation. For example, adding an short or intermediate-term corporate bond fund to a moderate allocation balanced fund (65% stock/35% bond) could reduce the allocation to 60/40; conversely, adding a mid-cap value fund to the 65/35 balanced fund could increase the allocation to 70/30.

The other method does not change the overall allocation. To increase risk tolerance, add non-core funds for both stock and bond allocations; for example, adding a mid-value or foreign large value fund along with a high-yield bond fund in the proper proportions maintains the original overall stock/bond allocation. To decrease risk tolerance, add less volatile fund categories to both stock and bond allocations.

What investment choices should be avoided in IRA and 401k portfolios? Annuities, leveraged funds, tax-efficient funds, very aggressive growth funds and most sector funds definitely have no place in these retirement programs due to either high annual costs, inappropriate risk and/or lack of total reinvested distribution potential.

Why do you prefer active-managed funds over index funds in IRA, Roth IRA and 401K portfolios? In addition to asset allocation and diversification, a critical factor is taking advantage of the compounding of total distributions in these plans to maximize the reinvestment of fund shares. Since the vast majority of index funds are tax-efficient, no capital gains occur unless the holdings of the particular index are sold for a profit. Historically, changes in broad-based index funds tend to sell poor performers for a loss rather than good performers for a profit.

What is a reasonable time frame to recover losses? Obviously, that depends on the extent of losses, future rate of return and future contributions. If an investor lost 40% in a year, then the investor would need a 67% cumulative return to recover the loss; with a 20% loss, investors would need a 25% cumulative return to recover the loss. However, if investors continued to add to retirement plans, the new contributions would reduce the time required for recovery of losses. To figure what is needed to recoup your particular loss, Kiplinger has a customized return calculator.

What significant challenges do retirees face in IRA 401k portfolios? In retirement, the major change is shifting from asset accumulation to asset withdrawal. Most retirees have safety of assets and income as their main goals with growth of assets secondary -- see Portfolio Changes in Retirement for more information. Another issue for those in retirement is whether to transfer their 401k to an IRA; most investors would gain flexibility of fund choices and increased control of portfolio by transferring to a no-load IRA.

 Summary

  • Tax-deferred compounding (tax-free compounding in Roth IRAs) of reinvested distributions is a key ingredient for successful IRA and 401k portfolios.

  • Appropriate asset allocation increases the number of shares - and asset value - using reinvested distributions with reduced volatility.

  • Core holdings should be well-diversified with established stock and bond funds -- high-quality balanced funds or fund of funds are ideal, preferably funds that are active-managed in order to maximize the compounding advantage of total distributions (interest, dividends and capital gains).