Best Types of Funds for IRA and 401(k) Portfolios

Many investors consider their retirement plans, e.g. employer 401(k) and IRAs (self-directed, traditional and more), as a substantial part of their total investment portfolio. When an investor experiences substantial losses in any part of their portfolio, it’s natural to ask questions about investment strategies, asset allocation decisions, and mutual fund selections in their retirement accounts.

Let’s consider broad financial market performance, various asset management strategies, investor concerns, and some of the key reasons that most investors take advantage of traditional retirement plans.

Market Performance and Investing for Retirement

Financial markets rise and fall over time. Investors in the recent past have enjoyed an extended bull market and historically-low interest rates.

Since it’s unlikely that any bull market will last forever, investors should consider what’s happened in previous periods of financial markets’ decline.

You must own assets that aren’t correlated with one another to diversify your portfolio and minimize your overall risk exposure.

During inflationary period, investing in hard asset like gold and other commodities is often a good idea. Investors should considering opening a gold IRA account or rolling over a 401(k) plan to a physical gold IRA.

What’s Likely to Occur When Markets Decline?

When broad market indexes decline, e.g. the Dow Jones Industrial Average (DJIA), it’s common to experience unrealized losses in your retirement investment portfolios.

For instance, relatively rapid and sharp market declines occurred during the Great Recession of 2008.

According to Morningstar, both domestic and international equity categories declined that year. It was the worst year for financial markets since the 1930s Great Depression period.

The following shows results for major U.S. and international equity indices in 2008:

• S&P 500 (large capitalization) (-37.88 percent)
• S&P 400 (mid-capitalization) (-37.21 percent)
• Russell 2000 (small-capitalization) (-33.79 percent)
• Dow Jones Moderate (balanced) (-25.18 percent)
• MSCI EAFE (international) (-43.56 percent)

Most bond funds showed negative returns as well. As investors turned to quality and relative safety, they turned to government and agency bond categories. Bond funds composed of U.S. Treasury and agency mortgage issues showed positive results that year.

It’s important to consider many factors regarding the best core holdings for your retirement fund during a market downturn.

If you get high quality financial assets and the broad market sells off, you may decide to acquire more funds according to your asset allocation to reduce your cost basis, or you may decide to invest in quality and relative safety.

Discuss your concerns with a qualified financial advisor.

The Great Recession of 2008

If you were invested in 2008, you probably asked some of the following questions:

• Should I continue to add money to my retirement portfolio? (Am I confident in my long-term decision to use the wealth-building potential of the financial markets?)

• Have I selected investments that are suitable to my risk tolerance?

• Do I have the proper asset allocation in place for my retirement investments?
Your answers to these questions are important. During periods of market decline, your commitment to a long-term investment strategy will be tested.

• Consider financial market performance over longer time periods to alleviate your current concerns in a market downturn.

• Use rolling five-year periods (1926 – 2008) to assess long-term financial markets’ performance.

• Analyze benchmarks, e.g. the S&P 500 index to visualize how markets rise and fall over time.

Consider the performance of various asset allocation strategies over annualized five-year period returns (average, best, worst):

• 100 percent equity portfolio = +10 percent, +29 percent, -12 percent

• 90 percent stock / 10 percent bond portfolio = +9 percent, +23 percent, -6 percent

• 50 percent stock / 50 percent bond portfolio = +8 percent, +21 percent, -3 percent

• 30 percent equity / 70 percent bond portfolio = +7 percent, +21 percent, 0 percent
Note that the 70 percent equity / 30 percent bond portfolio allocation has an annual return that’s 10 percent lower than the 100 percent equity portfolio allocation (9 percent vs. 10 percent) with significantly lower long-term volatility.

In the 30 percent equity / 70 percent bond portfolio allocation, note there’s NO negative return in the rolling five-year period scenario. (This is a highly recommended asset allocation for retirement portfolios for this reason.)

Other asset allocations show that portfolio volatility declines when equity allocations decrease. (History shows that when small-capitalization or foreign equities are included—even in small amounts—volatility and capital appreciation potential increase.)

How Do Market Statistics Relate to Your Concerns as an Investor?

Historical performance shows that all of the above asset allocation portfolios show positive long-term results:

• This should support your confidence as a long-term investor.

• This should also support your decision to evaluate current asset allocation distribution percentages (equity-bond fund percentages) and your risk tolerance profile.

• Answer: “What degree of volatility is acceptable to achieve a potential long-term return?”

• Apply this information to your 401(k) and IRA investments to take advantage of (1) time, (2) diversification, and (3) tax-advantaged investing.

401(k) and IRA Benefits in Retirement Investing

Two primary benefits exist for retirement plan investors:

• Deductions of your 401(k) and IRA contributions from gross earnings

• Tax-deferred accumulation of capital in your traditional retirement plan accounts

Almost everyone who contributes to an employer 401(k) or personal IRA account knows that they receive a front-end deduction but many people don’t take full advantage of tax-deferred accumulation on gains and reinvested earnings.

Simply put, it’s possible to reinvest capital gains, bond interest, and stock dividends in your traditional 401(k) and IRA without the impact of taxes.

Until you withdraw money from these accounts, you’re money grows. When you withdraw funds in retirement, the money is taxed at ordinary income rates. For instance, if you earn 12 percent in your tax-deferred 401(k) each year for six years, your money doubles!

Note that if you invest in a Roth IRA with funds net of taxes, your qualified withdrawals are tax exempted.

401(k) and IRA Strategies

The key to achieving retirement investment success is to take advantage of tax-deferred and/or tax-free compounding when you reinvest distributions.

If you systematically reinvest distributions in a mutual fund, you may automatically increase the number of shares you have in the fund over time.

This strategy provides a reasonable opportunity to capture positive returns with less long-term volatility.

For instance, if you reinvest distributions from your 70 percent equity / 30 percent bond allocation portfolio, you earn both compounded bond coupon interest plus stock dividends. Key takeaways include:

• This strategy allows you to add shares to your retirement plan with relatively low or average long-term volatility.

• Capital gains distributions in your mutual funds don’t occur as predictably as dividends and interest but can also be used to acquire more mutual fund shares.

• As the number of shares you accumulate increases, you see the dynamic impact of compounding reinvested distributions in your retirement portfolio.

Your Contributions, Employer Matching Funds, and Reinvested Distributions

You have three ways to increase your retirement account shares, including (1) your contribution, (2) your employer’s matching funds, if any, and (3) your reinvested distributions.

Value appreciation, of course, plays a desirable role in increasing your portfolio’s value. However, your portfolio value doesn’t add to the number of shares held in it unless you get new shares of subsequent profits, e.g. from a capital gains distribution.

Some investors make the short-term mistake of picking aggressive growth fund investments for most of their retirement portfolios. They assume that, over the long-term, aggressive growth equals higher than market returns.

However, when financial market downturns happen—and they do—it’s possible to feel the frustration of lower account values and the same number of fund shares.

While it’s okay to keep a small part of your retirement portfolio invested in aggressive funds, e.g. 15 percent or less, it’s great to emphasize distributions-generating investments (capital gains, interest, and dividends) in your core holdings.

These assets tend to reduce portfolio volatility and increase the number of fund shares you own.

Best Fund Categories

Fund categories that generate dividend, interest, and capital gains distributions are good choices for your traditional IRA and 401(k) retirement funds.

The following categories should be core holdings:

1. Moderate allocation, balanced funds: typically 60-70 percent large capitalization and up to 40 percent government and corporate bonds

2. Conservative allocation, balanced funds: typically 30-35 percent large-capitalization plus 65-70 percent government and high-quality corporate bonds

3. “Target-Date” funds: typically a broadly diversified fund-of-funds that ties allocation to retirement dates (see what are target retirement funds for more information)

4. Equities and/or bond fund-of-funds: choose an allocation according to general market conditions

5. Stock income/dividend growth: select large-capitalization value funds with an emphasis on established companies that pay dividends

6. Government and corporate bond fund: select short, intermediate, or long-term maturity date issues of U.S. Treasury, government agencies, and corporate bonds

7. Multi-sector bond fund: Invest in a broad spectrum of bond issues, including small emerging markets and high-yield issues

After discussion with an experienced financial advisor, choose from the following types of non-core holdings to potentially enhance your retirement plans’ returns (if you can assume more volatility:

• Foreign large-capitalization value: funds that invest in securities traded in established international markets

• Large growth funds: large-capitalization funds invest in higher than market average value-earnings ratio shares (in which income is a secondary objective)

• Mid-value – mid-capitalization funds: provide value appreciation potential (in which income is a secondary objective)

• Small-capitalization – small value funds: invest in low value-earnings ratio shares in search of price appreciation potential (in which income is a secondary objective)

• High-yield bond funds: invest in debt issues with high-income potential (with higher corresponding volatility)

Recommended 401(k) and IRA Allocations

Determine your general portfolio allocations, e.g. equity/bond percentages, before the process of identifying specific funds for your portfolio.

Use the following allocations as guidelines to achieve a reasonable reward and risk balance. Keep in mind the benefits of tax-deferred investing and compounding.

Time, or the number of years until retirement, is an important consideration as well:

• With 10+ years until retirement, use 70 percent equity / 30 percent bond asset allocation with a growth and income strategy

• With less than 10 years until retirement, use 50 percent equity / 50 percent bond asset allocation to shift towards increased income and lower volatility

• In retirement, use 30 percent equity / 70 percent bond to prioritize capital preservation and income

Risk Tolerance and Asset Allocation

In the above asset allocation examples, your risk tolerance can be conservative, moderate, or aggressive (see The Role of Risk in Mutual Fund Portfolios for more information):

• If your risk tolerance is moderate, consider the moderate allocation, balanced fund strategy.

• If your risk tolerance is conservative, select the conservative allocation, balanced fund category.

• If you’ve established target-rate retirement funds, consider a slightly higher risk tolerance level due to the higher exposure to equities in this allocation.

Electing two actively-managed fund-of-fund categories can provide additional benefits, including (1) broad diversification, (2) greater controls for managing your allocation percentages, and (3) greatest utilization of reinvesting distributions in interest, capital gains, and dividends.

For instance, in no-load fund-of-funds, e.g. T. Rowe Price Spectrum Income (RPSIX) and T. Rowe Price Spectrum Growth (PRSGX) can be used in any of the above asset allocation examples.

Periodic rebalancing (see Rebalancing Your Portfolio) easily maintains your allocation percentages.

Related Questions

1. When using one of the asset allocation models recapped above, how is risk tolerance increased or decreased?

One way is to add a fund that slightly shifts the overall asset allocation.

For instance, add a short or intermediate-term bond fund to a moderate allocation/balanced fund (65 percent equity / 35 percent bond). This could effectively reduce your allocation to 60/40.

In contrast, add a mid-capitalization value fund to the 65 percent stock / 35 percent bond to increase the allocation to about 70/30.

A second method won’t change your overall portfolio allocation: (1) To increase your risk tolerance, add non-core holding funds for both stock/bond allocations.

For instance, add mid-value or international large value funds plus a high-yield bond fund (in proper proportion) to maintain the original equity/bond allocations.

To decrease your risk tolerance, acquire less volatile fund categories in both stock/bond allocations.

2. What investments should I avoid in an IRA and 401(k) portfolio?

Avoid annuities, tax-efficient funds, highly aggressive growth funds, leveraged funds, and most sector funds. These types of investments have no place in your retirement plan accounts.

High costs, risk levels, and/or lack of reinvestment distribution potentials make these investments unattractive for your retirement plan strategy.

3. Why do you like actively managed funds instead of index funds in 401(k), IRA, and Roth IRA accounts?

Index funds don’t facilitate your ability to take advantage of compounding and, for that reason, they don’t facilitate your ability to reinvest in new fund shares. Many index funds are also tax-efficient.

Unless the holdings in a certain index fund are sold to book gains, you’re unlikely to see a capital gains distribution. Perhaps that’s because many broad-based index funds have the tendency to sell their poor performers at a loss. They’re less likely to book gains.

4. How long should it reasonably take for me to recover losses in my retirement account?

The answer to this question depends on how much money you lost, future contributions, and future rate of return.

Let’s say you lose 40 percent this year. You’d need a whopping 67 percent cumulative return to get even. To recover a 20 percent loss, you’d need a 25 percent cumulative return.

If you continue to contribute to the retirement plan, the amount of time you need to recover the loss is reduced. To determine what’s needed to recover your specific loss, use Kiplinger’s customized return calculator tool.

5. What challenges does a retiree face in their 401(k) or IRA portfolio?

After you retire, the major change in your return goals may shift from accumulating assets to withdrawing them. Many retirees prioritize the safety of capital and income as their primary goals. The growth of their financial assets is usually secondary. (Refer to Portfolio Changes in Retirement to learn more.)

Another issue for the retiree is whether it’s best to transfer 401(k) assets to an IRA account. In many cases, the investor gains more flexibility and increased portfolio control. Look for no-load IRA plans to save money on costs, too.

Best Types of Mutual Funds for IRA and 401(k) Portfolios

Remember, tax-deferred asset growth and compounding (or tax-free compounding in a Roth IRA) uses reinvested distributions as a primary ingredient for successful 401(k) and IRA retirement investing.

Appropriate asset allocation will increase the number of shares – and eventual asset value – by using reinvested distributions and reducing volatility.

Core holdings in your retirement plan should be well-diversified. Select only established stock and bond investments. High-quality balanced funds and fund-of-funds investments are ideal.

Actively-managed holdings also maximize the compounding of the interest, dividends, and capital gains in your portfolio.