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distributions ; all of these distributions are exempt from taxes until withdrawals, at which time 100% of the amounts withdrawn are taxed at ordinary income rates.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 holding s 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

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

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

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 ingredien t for successful IRA and 401k portfolios .