A Long, Critical Look Under The Hood Of My 401(K)

The first place we should look when discussing our personal investments is our 401(k).

I only say this because a 401(k) is likely the first investment account an American will encounter in their lifetime – not because it is the best investment account. In fact, the first account that deserves our attention when discussing investments is actually the Roth account, which can appear in both IRA and 401(k) form, but that’s a discussion for a later date.

The 401(k) has risen to popularity over the past 40 years not because it’s such an effective method for retirement saving and investing or because investors are so overwhelmingly enamored with their accounts – rather, it presented to businesses a cheaper and easier alternative to the traditional defined benefit pension account, because a 401(k) transfers responsibility for saving, investing and withdrawal to the individual employee/investor and away from the employer/plan sponsor.

So basically, for all of our talk of a wonderful tax deferred retirement savings vehicle, the 401(k) actually represents a screwing of the American worker by a team of business interests and politicians.

I Love/Hate The 401(k)

You can probably sense my enthusiasm oozing through your computer screen right now.

Yes, the 401(k) is tax deferred, meaning you do not pay federal income taxes on money contributed to a 401(k) up to an annual limit – in 2018, that limit was $18,500, rising to $19,000 in 2019. You’re also allowed an additional $6,000 in catch-up contributions beyond the age of 50.

Most employers offer a matching contribution if you participate in their 401(k) – in my case, my employer offers a 4 percentage-point match for contributions of at least 5 percent of my salary.

I am not a huge advocate for 401(k)s, but if your employer is generous enough to offer a match, I would argue that you should be funding your 401(k) at least up to the maximum match.

Many financial coaches and advisors will tell you that your next step should be to maximize your 401(k) contribution. I disagree.

Contributing to a 401(k) is an effective method for retirement saving for middle America and it should not be minimized, but there are better accounts available to those of us with different levels of wealth and different goals.

For example, if you’re looking at a traditional retirement and you have a decent backstop of wealth already built or through your family, your first priority after guaranteeing your employer match should be to maximize a Roth IRA account. A Roth IRA is funded after tax – meaning you’ve already paid your income taxes on the money – but all of the money contributed plus any growth it’s experienced comes out of the account tax-free on your own timeline.

In a 401(k), that money is subject to penalty if it comes out before age 59 and ½. Furthermore, that money is subject to your personal income tax, not the capital gains tax applied to most investments held in a brokerage account. Finally, you are required to begin withdrawing specific ammounts of money via “Required Minimum Withdrawals” at age 70 and ½.

As always with saving and investing, it’s deceptively simple. There are traditional IRA accounts that follow rules very similar to the 401(k) – and then there are Roth 401(k) accounts offered by some employers that follow rules very similar to a Roth IRA.

Whether or not one chooses to prioritize a Roth IRA or a Roth 401(k) after maximizing an employer’s match in the traditional 401(k) account should depend primarily on your comfort level with the 401(k)s investment menu. The investment menu available to your Roth 401(k) should be exactly the same as the menu for your traditional 401(k).

I am lucky enough to be offered a Roth 401(k) – but I do not like its menu nearly as much as I like all of the funds available in my primary Roth IRA account on Vanguard. Thus, for the time being, I only contribute to my traditional 401(k), and only in the amount sufficient to maximize my employer’s match.

My 401(k)

 Now that those nuts and bolts are out of the way, we should discuss the investments within my 401(k).

Current allocations:

• 33% in Schwab S&P 550 Index SWPPX
• 11.9% in DFA U.S. Small Cap I DFSTX
• 11.6% in DFA International Core Equity DFIEX
• 10.3% in Vanguard Mid Cap Index Fund VIMAX
• 7% in Vanguard Growth and Income VGIAX
• 5.9% in DFA Emerging Markets Core Equity I DFCEX
• 5.1% in American Funds Europacific Growth RERGX
• 4% in Janus Henderson Triton I JSMGX
• 3.5% in Goldman Sachs Large Cap Growth Insights GCGIX
• 1.6% in Vanguard International Explorer VINEX
• 1.7% in PGIM High Yield Z PHYZX
• 1.4% in Vanguard Short Term Federal Admn VSGDX
• 1.0% in Metropolitian West Total Return Bond I MWTIX
• 1.0% in Vanguard Mortgage Backed Seucrities VMBSX
• 1.0% in Vanguard Short-Term Inflation Protected Securities Index VTAPX

Current Contributions:

• 25% in Schwab S&P 550 Index SWPPX
• 10% in in DFA U.S. Small Cap I DFSTX
• 25% in DFA International Core Equity DFIEX
• 10% in in Vanguard Mid Cap Index Fund VIMAX
• 5% in in Vanguard Growth and Income VGIAX
• 15% in DFA Emerging Markets Core Equity I DFCEX
• 5% in Vanguard International Explorer VINEX
• 1% in PGIM High Yield Z PHYZX
• 1% in Vanguard Short Term Federal Admn VSGDX
• 1% in Metropolitian West Total Return Bond I MWTIX
• 1% in Vanguard Mortgage Backed Seucrities VMBSX
• 1% in Vanguard Short-Term Inflation Protected Securities Index VTAPX

Current allocations reflect the current balances in my 401(k) account, which has approximately $20,000 in it right now. Current contributions show where my new money, approximately $530 a month, is invested when they are deducted from my paycheck and my employer match is sent to my account. My current allocations are 93.9% stocks, 6.1% bonds, nothing in cash. Year to date returns, as of end-of-day on Monday, Dec. 3, have been -2.98%.

Line Up

 A brief commentary on mutual funds: I hate them. Even the low-cost, passive, easy to understand mutual funds like most of the ones I use in my portfolio are opaque dinosaurs that I wouldn’t buy in one of my personal accounts. I much prefer the ETF product structure, and my investing technique leads me away from active products and towards simple, passive index funds offered by one of a handful very large, low-cost managers.

That having been said, my 401(k) offers a great lineup of investments. I hold all of these asset managers in high esteem, these are all well-run funds that, for the most part, carry expense ratios and other investment costs well below those of their peers. Most of the funds in my 401(k) are either index funds, or funds that use a very strict but simple quantitative process to select and weight stocks within their portfolios.

Not all index fund investing is passive. If one is not a vanilla market-based investor, then a rational asset allocation is based on one’s assumptions of future market behavior and will necessarily deviate from the market portfolio.

My asset allocation in my 401k deviates from the market in two ways. One, I don’t believe that I should go out of my way to represent fixed income in my 401(k). Two, I am overweighting international and especially emerging markets funds because this is where the majority of the world’s economic growth will be in the next 20 years.

Bond Mutual Funds (They're Not Bonds)

 To date, I have allocated about 5 percent of my contributions to fixed income mutual funds – give or take a percentage point or two – and I’m considering reallocating future contributions from fixed income products and to one or more equity products.

The reason I would do so is that a 401(k) – or a 403(b), 457(b) or traditional RIA – are terrible places to keep your bonds. All distributions (withdrawals) from these accounts are taxed as ordinary income – meaning all of your bond yield is subjected to federal and state income taxes when it comes time to take distributions from your accounts. Current law requires distributions from these accounts to begin the year the investor reaches 70½ years old.

Yet some bonds, like U.S. Treasurys and agency bonds, don’t incur state or local taxes, while others, like municipal bonds, are exempt from federal, state and local taxes. Holding these bonds in a 401(k) means losing their tax benefits, which over very long periods of time end up representing a significant portion of their return. Three of the five bond funds in my 401(k) are government bond funds – a fourth, MWTIX, is a “unconstrained” fund allowing active management to seek out the best opportunities they can find within the fixed income universe to generate a total return.

The only bond fund that passes muster is PHYZX, a high-yield bond fund that provides my 401(k) some modest diversification for a price – the fund carried a 55-basis point (0.55%) expense ratio.

We're encouraged to buy more bonds as we get older because bonds and other similar fixed income investments usually provide a greater level of financial security and protection against loss of capital than other asset classes. With bonds, the investor is pretty much guaranteed to earn interest, or a coupon payment, for a certain period before their initial investment is returned to them.

Part of that benefit is lost when we invest fixed income via a mutual fund - the asset managers buying the bonds still have the security of a return of principle should they hold a bond to term, but all of that security is not passed down to the end investor, who has as little certainty that they will gain, maintain or preserve assets as they would in an equity fund, and is almost certain to have sacrificed some of the potential return they would get from an equity fund by choosing to invest in fixed income. Fixed income mutual funds deliver excellent diversification benefits, but they aren't nearly as powerful when it comes to the preservation of wealth as a humble Treasury bond (which can be purchased from TreasuryDirect by individuals and intermediaries).

A Closer Look At Equities

On the equity side, I mostly like where my money is going. I chose inexpensive, passive funds on my 401(k)’s menu on purpose, as these characteristics benefit long-term investors trying to compound their wealth. I do overweight emerging markets and international stocks in my 401(k) for the time being – I will likely come off this overweight as I cross the age of 40 and it’s time to dial back on some of my risk-taking. Over the longer run, tax-deferred accounts are not the best place for potentially high-growth investments like emerging markets funds because our withdrawals will eventually be taxed at the personal income tax rate and we’d rather those returns receive the more favorable capital gains tax treatment – or, even better, occur within a Roth account where gains are not taxed at all.

That brings me to a separate point before I do some more in-depth analysis of the investments offered to me within my 401(k). I have a Roth IRA account that I love and is my primary focus when investing – but I also have a Roth 401(k) option offered by my employer. I think 2019 is a good year to employ that option, but I’m deferring making any move on that until after Jan. 1 has passed and holiday spending is behind us. Contributing to the Roth 401(k) belongs on my list of 2019 resolutions!

So I wanted to think more closely about the investments offered within my 401(k) and whether I was making the right choices.

I look at some of the more expensive active funds on the menu and mostly come away unimpressed. For example, funds like PMBPX, RERGX, GCGIX and JSMGX all post impressive returns before expenses, but do not provide significant diversification to my portfolio – as each are 90 percent or more correlated to the U.S. equity market – and carry significantly higher expense ratios compared to the passive funds I’ve chosen.

In at least two cases, active funds offered a significantly higher compound annual growth rate than a similar passive product I’ve chosen. I used FINRA’s mutual fund comparison tool, which considers potential returns net expenses, to see if the additional growth could overcome the additional cost to invest in the funds.

The first pair of funds I compared were the Schwab S&P 500 index, SWPPX, which has offered a 14.05% compound annual growth rate over the past five years, with the Goldman Sachs Large Cap Growth Insights Fund, which has delivered 16.23% compound annual growth over the past five years.

Using FINRA’s Fund Analyzer tool, I calculated what the performance of a $10,000 investment in each fund looks like after expenses and fees over a 10-year period using different assumptions for returns.

When I assumed a flat 5 percent growth for each fund, the lower expense-ratio fund naturally beat its more expensive cousin. SWPPX returned $16,240.16 after paying $38.61 in costs, while GCGIX returned $15,432.72 after paying $676.11 in costs.

It’s doubtful that two different funds would both experience 5 percent growth over the next 10 years – so let’s look 10 years out using the compound annual growth rate (CAGR) from the last five years (2013-2018).

Using these assumptions, it looks like GCGIX’s whopping 16.23% CAGR is worth the additional expenses, as a $10,000 investment in the fund would return $42,631.94 after 10 years after incurring $1,215.25 in expenses; while SWPPX’s 14.05% CAGR would offer me $37,123.61 for my $10,000 investment after paying $62.04 in expenses.

However, the last five years have encompassed one of the most dramatic periods of growth in one of the longest bull market runs U.S. equities have ever seen. Large-cap growth stocks are unlikely to offer the double-digit returns I’ve enjoyed thus far. A better comparison might be to use historical rates of return – since inception, SWPPX has returned an average of 7.56% each year, while GCGIX has returned 7% annually.

If we applied historical rates of return to each of these funds and look 10 years out, SWPPX would return $20,663.56 with $44.08 in expenses, while GCGIX would return $18,637.51 after paying $749.17 in expenses.

My other comparison between a more passive, inexpensive fund in DFSTX, Dimensional Fund Advisor’s Small Cap Portfolio which offered a compound annual growth rate of 12.05% over the past five years, and JSMGX, Janus Henderson’s Triton Fund (another small cap focused product), which grew at a compounded rate of 14.86 percent over the past five years, turned out quite differently.

Assuming a flat 5 percent future growth rate over the next decade for each fund, DFSTX would have offered me $15,697.30 after paying $467.51 in expenses, while JSMGX would have offered $15,081.84 after paying $952.30.

Using the compound annual growth rate as our assumption, DFSTX would offer a $30,064 return on a $10,000 investment after paying $674.43 in expenses, while JSMGX would offer $37.004.41 after $1,589.18 in exepnses.

Using historical rates of return, JSMGX looks even better 10 years out. While DFSTX has returned an impressive 10.35% annually since reception, but is overshadowed by JSMGX’s 17.37 percent average annual return. After investing $10,000 for 10 years, DFSTX would return $25,825.58 on an initial investment of $10,000 after paying $617.16, JSMGX would return $45,934.33 return after paying $1,814.85 in expenses.

The takeaway is that switching out some or all of my SWPPX allocation for GCGIX isn’t worth the trouble or time – but replacing some or all of DFSTX with JSMGX does make some sense.

Quick Conclusion

 Was that in-depth enough? I feel like I'm only skimming the surface! 

I’m turning 38 years old in 2019. I don’t see anything too out-of-whack with my current allocations – but I would probably benefit from tweaking my future contributions?

So how do I allocate my 401k contributions moving forward? For one thing, I will begin adding to my Janus Henderson Triton fund allocation each month – right now, the fund is a proven winner with strong management in both up and down markets. I love Dimensional Fund Advisors investing methodologies and strategies, though, so I don’t want to take too much of my allocation away from their small cap product.

I will also dial back my contributions to fixed income mutual funds – likely in favor of more fixed income investing via my brokerage accounts in 2019. I will drop the Vanguard fixed income products from my future contributions, as these kinds of allocations are more beneficial held in a taxable account.

New Contributions For 2019:

• 25% in Schwab S&P 550 Index SWPPX
• 5% in in DFA U.S. Small Cap I DFSTX
• 25% in DFA International Core Equity DFIEX
• 10% in in Vanguard Mid Cap Index Fund VIMAX
• 7% in in Vanguard Growth and Income VGIAX
• 15% in DFA Emerging Markets Core Equity I DFCEX
• 6% in Vanguard International Explorer VINEX
• 5% in Janus Henderson Triton I JSMGX
• 1% in PGIM High Yield Z PHYZX
• 1% in Metropolitian West Total Return Bond I MWTIX