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Investors often ask us how to follow our model portfolio suggestions in
conjunction with 401(k) and similar retirement plans that have limited
options. This is a good question, one that’s easier to understand if you think
of an analogy: What if the issue were having a balanced diet instead
of a balanced portfolio?
Imagine for a moment that you had a job where the only lunch option was to eat from vending machines. You could either eat the machine food or go hungry. Most likely you’d eat. And naturally, you’d want to fill the gaps in your diet outside of working hours.
That’s the basic model for incorporating the limited options of a 401(k) plan into your overall investment portfolio.
Nutritionists often recommend a certain number of basic food groups (I personally like the tongue-in-cheek lists that include necessities such as pizza, coffee and chocolate). Their general advice is to make sure you get a balanced diet made up of the right proportional sampling of all these basics.
Likewise, we recommend specific asset classes to make up the equity part of a properly diversified portfolio. Our recommendations: U.S. large-cap blend, U.S. large-cap value, U.S. small-cap blend, U.S. small-cap value, international large-cap blend, international large-cap value, international small-cap blend, international small-cap value and emerging markets. In retirement accounts, including IRAs and 401(k) accounts, we also recommend U.S. real estate investment trusts and international real estate investment trusts. (You will find these asset classes in list form later in this article.)
Very few 401(k) and similar plans give you access to all those asset classes. That means you probably can’t get the full diversification we recommend if you have all your money in a retirement account. (Similarly, it’s not likely that you can get a properly balanced diet from vending machines.) The answer is relatively simple: Go elsewhere to make sure you get what’s missing.
In this article I will show you how to get the major investment bases covered. If you have a financial advisor, you may be able to implement a more sophisticated solution than what I describe. However, what follows should be a good start, and for some people it might be enough.
Of course you will want to put the right overall percentage of your account into fixed-income options like bond funds. Determining that percentage is beyond the scope of this article, but you’ll find some good guidance in “Fine-tuning your asset allocation.” My discussion involves equity asset classes.
What’s in your 401(k) plan?
Your first job is to do the most with what’s in your retirement plan. To do that, you have to know exactly what’s there.
Start with the following list of our recommended equity asset classes. You might want to copy this onto a blank sheet of paper.
Recommended equity asset classes:
- U.S. large-cap blend
- U.S. large-cap value
- U.S. small-cap blend
- U.S. small-cap value
- U.S. real estate investment trusts
- International large-cap blend
- International large-cap value
- International small-cap blend
- International small-cap value
- Emerging markets
- International real estate investment trusts
Next, put a check mark beside each asset class on the list that’s available in your retirement plan. Getting that information might be easy or it might be challenging.
- If yours is among the dozens of private and government retirement plans that our experts have analyzed at 401khelp.com, this part will be easy. In the description of your plan, you’ll find a list of recommendations, each one identified by asset class. Those are the asset classes you should mark on your list.
- If your plan is not listed at 401khelp.com, then you’ll have to do your best to sleuth out this information. From your plan’s literature or web site, read the description of each investment option and determine its asset class. For a publicly traded fund, you can find the asset class online at Morningstar.com. On your list, mark each asset class from which you can choose.
You’ll almost certainly have some recommended asset classes that haven’t been checked. Now that you know what they are, you can go about getting them. This is equivalent to eating well when you’re away from the vending machines at work.
Investing outside your 401(k)
The unchecked items on your list are the asset classes you need to access with your outside investments. That could be in an IRA (either Roth or traditional) or in taxable accounts.
Start by finding funds to fill each blank spot. You can choose from among the exchange-traded funds in the Merriman Model ETF Portfolios or from among mutual funds in our Fidelity, T. Rowe Price or Vanguard portfolios (which you will find online at FundAdvice.com).
One good approach is to start with Vanguard’s low-cost funds and use ETFs to cover the international small-cap value slot (and in an IRA, the international real estate slot), which Vanguard doesn’t have. Remember, you’re probably not going to be able to do this perfectly. It’s more important to get the right asset classes than it is to get the absolutely best fund for any given asset class.
Getting the right balance
In a perfect world, you’d have the right number of dollars in each of your accounts to follow our percentage recommendations. In the real world, you won’t be able to do that if you are regularly contributing money to your retirement plan or if that plan has much less or much more than your other accounts.
If you have money invested outside your 401(k), start by filling in the blank spots on your list. Can you put enough dollars in each asset class so that the total in all your accounts conforms to our percentage recommendations? If so, you’re on the right track.
If you have substantially more money invested outside your 401(k) plan than in it, you might want to eliminate one of the asset classes inside the plan and fill that slot with something on the outside. This approach is very logical. However, you could wind up with a retirement plan account that sometimes appears to be underperforming. If that happened, you could incorrectly conclude that “there’s something wrong” with that account.
Another good approach, one we often take with our clients, is to have the outside accounts properly balanced with all asset classes while you do the best you can in your retirement account. In nutrition terms, this is like making sure you eat a fully balanced diet when you’re away from the vending machines.
A professional advisor can help you determine what makes the most sense for you.
Finding the money
If your retirement plan at work makes up all or most of your portfolio and you can’t get the right balance of funds in that plan, you are facing a different challenge. If you are still contributing to the retirement plan, it may be advantageous to divert some of those regular contributions to an IRA or a taxable account in which you have more investment choices.
Our general recommendation is to contribute as much as necessary into your 401(k) or similar plan so you qualify for any matching funds. After you’ve done that, additional savings may do you more good in an account with more choices. This may be to your benefit even if it requires you to give up a tax deduction and thus invest fewer dollars into an IRA or a taxable account.
The immediate tax deduction of a 401(k) contribution is very appealing. But mathematically you might have a similar long-term outcome if you paid the tax now, invested fewer dollars and eventually withdrew those dollars without paying any tax (in a Roth IRA, for example) or paying only reduced capital gains taxes (in a taxable account).
If this is starting to sound rather complex, then you are accurately tracking the discussion. Some investors will find this exercise helpful and easy to implement. For others, it will be more than they can deal with. If you are in the latter camp, the best approach may be to find a financial advisor to help you sort this out.
Despite the difficulties, this is well worth doing.
If the majority of your “dining” is at vending machines that deprive you of necessary food groups, you won’t have the best diet. Likewise, if the majority of your investing is done in an account that deprives you of the best asset classes, your money won’t work as productively for you as it should. You can fix that, and you should do so.
Richard Buck is publications manager of Merriman.
Further suggested reading: “The ultimate buy and hold strategy”
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