Company Retirement Plan Strategy for Long-term Success. Understanding Traditional vs. Roth 401(k) plans

Welcome to another episode of Blue Chip Now recorded 07/31/24. Today, we are going to be talking about ways to properly allocate a 401k plan.

[0:28] Daniel: That includes common mistakes that we see individuals potentially make when allocating a 401k plan. You have Daniel Ducina, Matt Mondew, Dan Cedar, your usual suspects from Blue Chip Partners. Quick call out. We are always looking for feedback that includes topics you'd like to see covered. General, I would say, areas of interest or anything you liked or don't like about how we're doing these podcasts. You can email us at podcast at bluechipfm.com. email address is shown on the screen here. We're always looking for engagement with the audience, so do not hesitate.

[1:03] Daniel: Reach out to one of your Blue Chip team members or, more formally, the podcast email address. So, topic du jour, 401k allocations, how to properly allocate, and I think you teed it up very well. Just on the headline, I'll start the conversation by saying, maybe this is not accurate, but my general feel that I get, because I generally am behind the scenes most of the time, not on the front lines like you two.

[1:28] Daniel: But one of the most common things that I think happens is people think of their 401k as some separate entity because it's uber long-term in nature. And people think that they're not going to be tapping into it anytime soon. They almost treat it differently, like just mentally. Does that make sense?

[1:47] Daniel: Yeah,

[1:47] Dan: very much so. I mean, it's often a really large part of their investable assets. So- it's not only treated differently, but it's really, really important because it's usually a large component of their overall balance sheet.

[2:02] Matt: I mean, for a long time, 401ks were boring to invest, right? You had a limited menu of options. You really had traditional 401ks, so pre-tax contributions. There wasn't a lot of excitement around 401ks, but I would say that's changed.

[2:17] Dan: How so? What do you mean?

[2:19] Matt: So, I mean, I think we see almost 100% of 401ks that come in, people. people showing us their statement, looking for advice, have Roth options now. In a lot of cases, they have after-tax investment options, which is a whole separate subject. But even more frequently, I see brokerage link options, which were you can actually self-direct your 401k outside of that standard mutual fund chassis with a limited menu. And in some cases, invest in individual stocks, which I think really opens up the possibility.

[2:51] Matt: So I guess my point is, If you haven't looked at your 401k in a while, things may have changed. They're changing at a quick pace from the way from when I started with Blue Chip eight years ago to now, I see a lot more interesting options and availability within 401ks. And when I say 401ks, everybody should know we just mean workplace retirement plan. This can be 403b, the name can change, but think workplace retirement plan.

[3:16] Dan: Yep. I'm glad you said that. Matt, let's peel that onion back just a little bit. So the traditional 401k plan or company retirement plan has some menu of limited investment options, right? So a lot of times that'll be mutual funds. So we generally don't see individual stock holdings within the menu of investment offerings. I think what most plans try to do is limit the number of available investment options to simplify. what their participants get to choose from.

[3:53] Dan: Because if they have the universe of individual stocks or bonds or investment products to choose from, sometimes there's paralysis by analysis where they end up doing nothing. And so I think that was kind of the genesis of these target date funds because it gives people, they're mapped into, and I want to go into target date funds as well, but it gives people an automatic. default based on their age. So let's table that discussion for a second. But I want to go back to your earlier point.

[4:25] Dan: So the traditional platform has a limited number of mutual funds that are generally offered. And that could be what, 10 to sometimes maybe 30 different investment options to choose from. But you're saying there are also, you're seeing emergence of companies that offer something called brokerage link or a self- directed brokerage account. And that's an offshoot of what the standard default menu is. And it allows the participant to go into the open market. as an offshoot of their 401k and invest in virtually whatever they want. ETFs, mutual funds, stocks, bonds, other types of products.

[5:11] Dan: So it really expands the offering, but it takes the participant to initiate this link. It's not the standard offering to most employees. It's something that the participant, if they're looking for more than just the plain vanilla standard investment offering. they can go out and get a little more sophisticated.

[5:34] Daniel: So before we get too far into the weeds, I feel like it's a good idea to start high level and work our way down. So we talked about company retirement plans. You traditionally had your standard traditional pre-tax option, right? That's your standard 401k. As Matt noted, in recent years, the prominence of Roth IRA, I'm sorry, Roth 401ks, is a big part of the company's history.

[6:00] Daniel: has increased so that's dollars that are put in after tax and then later you're not taxed on them on withdrawals so the first kind of layer really is vehicle structure whether it's a 401k 403b that's the first layer after that you start to get into okay within this vehicle structure how is it actually allocated and that's a lot of what you were just talking about so maybe before we even talk about investment options and all that What are the advantages and disadvantages of a traditional 401k versus a Roth?

[6:33] Daniel: Like who would use one or the other? Should you use both, right? Just some opinions there for, I would say the average individual, I think is always good.

[6:41] Daniel: Yeah,

[6:41] Dan: I think it's a good place to start. Go ahead, Matt.

[6:43] Matt: I mean, I think it always comes back to planning. I think conventional wisdom is that the person who makes a lot of money is going to get a larger benefit by doing pre-tax contributions, which is true. But in a lot of cases… with proper planning and depending on asset structure outside of the workplace retirement plan, you can find that that person could be better off in the long run making Roth conversions or Roth contributions, Roth 401k contributions.

[7:10] Matt: So instead of taking the pre-tax deduction now, actually paying the tax today so they don't have to pay it later. And I say, again, counterintuitively, and this isn't a general recommendation, but just so people think outside the box. A lot of times people think when you're younger, you're starting off. you're in a lower tax bracket, it's great to contribute to the Roth.

[7:32] Matt: And in some cases, it's worth bringing up scenarios where, hey, if more money can go in because you're deferring tax, that younger saver gets to see a bigger balance and the snowball compound and grow, and that creates some momentum and more incentive to save. So in a nutshell, the answer to your question is it depends. It's a conversation with the individual. And oftentimes, it's a look deeper into a greater financial plan.

[7:58] Dan: I think those are all great points. I would add that it's also a difficult analysis to really nail down because no one knows what future tax rates are going to look, what they'll look like down the road. And so I think most CPAs would argue, and this isn't, there's no right or wrong answer here, but they might advocate for pre-tax deferrals because we can guarantee that you're going to get the X benefit this year. by making a pre-tax deferral.

[8:31] Dan: The benefits of a Roth 401k account compounding and that snowball rolling for years or decades down the road has tremendous benefits, not only for the participant because Roth accounts don't require required minimum distributions, they also can continue to compound after your death on a tax-free basis for your heirs. So there's a number of reasons to justify, regardless of the tax rates down the road, the benefits of Roth. But there's just different styles to advising clients. And I think the standard CPA would say, let's take what we can get this year.

[9:17] Dan: We don't necessarily know what the future has in store. So if we can get the tax deduction this year. Let's take it. There's not a right and a wrong answer. There certainly could be a preference, not only by the client, but by also the advisor. So whether it's the financial advisor, the CPA, but I think, Matt, the first thing you said is it's all predicated on planning.

[9:40] Dan: And so instead of taking a dart and throwing it against the board and saying, I hope this works with some intention, some thought and some analysis, you can come to, I think, a reasonable approach or strategy that works for you.

[9:55] Matt: Yeah, it's a holistic approach, right? You don't want to just look at each account in isolation. You really want to combine everything and plan for the whole entire household.

[10:04] Daniel: Yeah. And so I think that that segues nicely into the kind of one layer deeper, right? So we talked about vehicle structure and pros and cons, if you even want to call them that, or just different uses for each. But The investment options within these workplace retirement plans, I mean, they can be very different employer to employer. And so I think just one observation that I have from acquaintances, conversations with prospective clients and current clients, I feel like there is some degree of just set it and forget it, right?

[10:39] Daniel: It's one of those things that, like I said at the onset. people view this as probably the most long-term of investment vehicles for them and so they plug it in and they kind of just let it go which can work out well if people get lucky but at the same time you know i think it's one of those things where the vast majority of individuals do not take that allocation into like into their holistic allocation into account when they're allocating their 401k plan yeah and you know that that's something that I think we should unpack.

[11:13] Dan: Yeah. Well, you know, when you talk about set it and forget it, it's been fascinating over the course of my short career to see, to review a prospective client or a client's 401k allocation and to see an allocation of, let's say, a portfolio really heavily concentrated in something like small cap. And you say to yourself as the advisor, How does that happen? How does somebody let this large component of their overall portfolio, let the allocation become so skewed?

[11:50] Dan: And it's because what a lot of participants will do is they'll look at the investment options that are available to them and then look at the one, three, and five-year track records of those investments and they'll pick whatever's doing the best at that time. So the recency bias of At that time, small cap was probably outperforming. They picked a bunch of small cap investments because they looked good on either a one, three or five year basis, and then they never go back and review it.

[12:20] Dan: And so you can almost understand from looking at an allocation that's totally out of whack at what point in time in history they picked those investments because they picked those investments based on what was working at that time.

[12:35] Matt: Right. I often see, you know, three large cap growth funds and those people, you know, thinking you've diversified because you picked three funds, but in reality, the overlap in holdings is nearly a hundred percent. Well,

[12:47] Dan: what's been working for the last 10 to 15 years is large cap. Yep.

[12:52] Daniel: Yeah. And so, you know, even with that, I think most workplace retirement plans have to the higher end of what you mentioned as like the range nowadays, at least just from what I've seen. I don't think it's really 10. I think it's closer to 30, 30 plus nowadays. And so that can be confusing when you've got large cap, blah, blah, blah, small cap, yada, yada, yada. It's hard to really understand what you're getting into. And I don't think that the average individual is going to go in and do an overlap analysis.

[13:27] Daniel: So what do people do? They pick the target date fund that has a number on it that should be used to. denote when that individual is planning on retiring and they throw it in that and boom, diversification. And I think talking a little bit about some of the pros and cons of those, even though we've talked about it at points in the past, is beneficial because they do have a very, very large presence in employee retirement plans.

[13:51] Dan: Daniel or Matt, why don't one of you break down what exactly is a target date fund?

[13:56] Matt: So in a nutshell, a target date fund is created based on an anticipated retirement date. They're usually in five-year increments, so it'll be 2055, 2060, 2065. And based on that time horizon between today and that target date, retirement date, they create an allocation. So the further out the retirement date is, the more aggressive the portfolio is, the closer the retirement date. So if we were 2030, you would expect a far more conservative portfolio allocated more to fixed income than equities. But that's one component of risk.

[14:33] Matt: So my retirement date doesn't necessarily correlate with my risk tolerance. And I think that's the big issue with target date funds.

[14:40] Dan: And just so listeners understand, if they're not aware, as you move closer towards the retirement date, the portfolio automatically adjusts. So it's going to auto-rebalance so that if it was initially very aggressive because your retirement date was very far away, the closer you sail towards… that retirement date, the portfolio automatically becomes more conservative by shifting from stocks over to bonds.

[15:09] Daniel: Yeah. But I think one of the bigger issues you get in those vehicles is just the visibility isn't great. So let's just say for argument's sake, you have investor A who has 50% of their investable assets in that locked in employee retirement plan, call it a 401k. And the other 50% of their investable assets are individually managed. And the bulk of that individually managed asset base is in an S&P 500 index fund. And that's fine. The domestic equity market on a cap weighted basis has done fine, has done well.

[15:48] Daniel: But when you think about the top heavy nature of that index, you've got a really high allocation to just a few names in that self-directed side of the equation. Well, within a target date fund, what if you have a situation where there's also a heavy concentration in those, call it top five names in the S&P 500 index? All of a sudden, you've got a risk exposure to just a few names that's pretty darn high. And that's where some of the cons of target date funds come in.

[16:16] Daniel: The visibility isn't good and you can end up overexposing yourself or over concentrating your portfolio and you don't even know it.

[16:22] Dan: Yeah, I would say another, I mean, another flaw that I've seen, which has been, there's been an argument for a long time about how undervalued segments of the market are like emerging markets or international investments. And most target date funds have a significant allocation to international. And really what they're trying to do is they're, it's almost like roulette. They're putting chips on each number. So they're spreading out across not only, you know, large cap, mid cap, small cap, but you're getting international types of investments.

[17:00] Dan: And for north of a decade, international investments have been a massive relative underperformer. to the US markets. Frankly, they just haven't kept up because of our exposure to segments of the market like technology.

[17:17] Dan: And so international investments have been massive, massive underperformers, but the equity, the target date retirement funds that are 2060, that are really far out, that are almost entirely stock-based might have upwards of 35% of the portfolio-

[17:37] Matt: It's greater than that.

[17:37] Dan: Earmarked. 35 to

[17:39] Matt: 40? I mean, 40 plus.

[17:41] Dan: 40 plus percent of the portfolio earmarked to international investments. And now, you know, there's been a longstanding argument, well, international is cheap, it's going to turn around, how can you not buy it at these valuations? Eventually, those individuals making that argument are going to be correct. A broken clock is right twice a day. So eventually, they're going to be right. But they've been wrong for north of a decade. almost 15 years. And so I think another issue with a target date fund is it's not transparent.

[18:15] Dan: You don't know the allocation between not only large, mid, and small cap, but domestic versus international. And they've been massively overweighted towards international for a long time.

[18:26] Daniel: The other big elephant in the room with target date funds is that there's a lot of different providers for these target date funds, and all of them are managed very differently. Some of them use cap weighted indexes. Some of them are actively managed. And then some of them have explicit capital market assumptions that the parent firm is putting forth. So they're going to inherently have more equity exposure at every target retirement year. You have to know what you own. And more importantly, the whole idea behind a 401k allocation that doesn't talk to the other.

[19:05] Daniel: investable assets is, in my view, the biggest mistake that people make with 401k plans. Yeah.

[19:10] Dan: It's lack of coordination. There's a lack of coordination. And I think it's something that the average investor assumes is on autopilot. While it might be adjusting over the course of the glide path towards retirement, it doesn't necessarily mean it's appropriate for that investor.

[19:32] Matt: Right. And I'd argue no investor should just say, oh, what I did, the investment I chose at 26, I'm just going to trust that that is going to take care of itself by the time I'm 60. You have to take some control. I personally have reviewed 401ks as an analyst, and I've come across target date funds that are infinitely more expensive than an allocation that I could select based on index funds in that 401k. I mean, so people have been at it.

[20:01] Matt: disadvantage in some cases for choosing a target date fund that's supposed to kind of just take care of them and have their back. And I just, reality is that's not always the case. And there can be less expensive options, allocations that we can build with very similar, if not better diversification.

[20:18] Dan: Yeah. And I, well, so it brings up the point that within the traditional retirement platform. All products have some type of internal cost. Most products, I guess I should say, in the event that there was some mutual fund that waived its fees or didn't have internal expense ratio, my guess would be that most of the products inside a 401k platform have some cost. And so it's important for investors to remember cost directly impacts performance. if you can keep the cost low. And the other recommendation is stay properly diversified. So cost low, properly diversified.

[21:07] Dan: And keep in mind, again, let's just touch back on the target date funds for one more second.

[21:13] Dan: If a fund gets more conservative over time and takes you almost to bonds, all bonds when you retire,

[21:21] Matt: well,

[21:22] Dan: is a predominantly bond. portfolio appropriate for you as an investor if you're still going to live for decades in retirement? And so it's a reminder when you're working with your advisor to put your portfolio in context of not only the rest of your life. Retirement isn't the end. Retirement oftentimes is just the beginning of the next chapter. And you could live for another 30 years. So having the appropriate balance between stocks and bonds. is something that you likely want to control yourself as opposed to letting a product control it for you.

[21:59] Daniel: Right. Yeah. And that's where you see the mistake. Like, okay, what is your perception of risk averse versus Vanguard or Fidelity or T. Rowe Price, right? Because they could be very different, right? Like you as a conservative investor approaching retirement could be a 60% equity, 40% fixed income split. I don't know if it is the same at Vanguard or not, but That's again, just one of the things with target date funds that I would highly, highly recommend any individual be aware of and look into.

[22:30] Matt: Well, yeah. I mean, these are one size. They're meant to be one size fits all. This is like going to a store and there's one size shirt and not knowing you. This is the selection that you have. Obviously, there's different dates, but for a 2055, let's just say pick on that. This is a one size fits all. They do not know you. They do not appreciate your other circumstances outside of this.

[22:53] Matt: Their job, that 2055 fund, I would almost assure you their job is to not ruin that so that they don't get sued by people saying my portfolio is down 20% in a year, I was going to retire. That's their sole focus. That's their motivation. It's not to give you the best allocation or the best advice.

[23:11] Daniel: What about, so I guess moving away from the target date fund allocation, do you guys have any observations that you've seen commonly across statements that you've reviewed in terms of any mistakes or other kind of blanket recommendations when you actually think about the composition of those vehicles?

[23:31] Matt: I got one that's top of mind. So there'll be a direct correlation in how large your plan is or how big the company that you work for and the funds that are offered. So a lot of times when retirement plans are small, meaning the group plan, so the whole 401k for the company. A lot of times that 401k provider needs to make a certain amount of money on this group plan. So what you're going to often find in there is a lot more higher cost fund options.

[23:57] Matt: Now, there might be an index fund sprinkled in there as well that we want to pull out and allocate to, but all else being equal, I think smaller plans are going to have more expensive investment options. Larger plans generally are made up of a lot of index funds and the choices are a lot better. So I think… As the individual investor, you need to know what kind of plan you're in. Always look at the fund. You can type it a lot of times in Google. Google the fund, the five symbol ticker.

[24:27] Matt: You can probably find the expense ratio. So these are just not saying less expensive, more expensive is better, not better, but it's worth being aware of. And that's one observation I have.

[24:36] Dan: I would say set it and forget it is the most common mistake I see. My recommendations, you know, I'll… I'll scan through and understand what target date funds are available and what they look like. I want to scan through and understand what the other traditional investments are comprised of and what they look like. And I kind of always go back to two fundamentals, which is keep costs as low as possible and stay properly diversified. And so if I can keep costs low and stay diversified, within a target date fund and it's appropriate, fine.

[25:16] Dan: If I can keep costs low and stay diversified by structuring a customized portfolio within the 401k, fine. But the point is, is I'm looking at these things for clients and every… plan participant should have their financial advisor go through what's available to them so that their 401k or their company retirement plan is in line with their needs and objectives and the remainder of their portfolio held outside of the plan.

[25:45] Matt: Right. Yeah. And get the most out of the plan. Get the most out of what's available to you.

[25:49] Daniel: Right.

[25:50] Dan: And so I think that it's the number, it's one of the most common components of the balance sheet. that gets overlooked. And I know that here at Blue Chip, we're committed to making sure that we're looking around every corner and uncovering any opportunities. Right.

[26:09] Daniel: Yeah. You can't build a financial plan without a big chunk of it missing, right? A big variable that you have question marks around.

[26:14] Dan: That's right. That's right. Anything else?

[26:17] Matt: Ready to call it a wrap. That was a spirited discussion and there's probably a lot more we could go into.

[26:22] Daniel: Yeah. Yeah. There's a lot of rabbit holes off of employer retirement plans. Certainly will be touching on aspects of it in the future, without a doubt.

[26:31] Dan: But Daniel, before we wrap, maybe could you just touch on how people can find us and, you know, the best avenue for listeners?

[26:39] Daniel: Yeah, absolutely. So, you know, of course, you can find us online, Blue Chip Partners. But also these episodes are all, in addition to being available from an audio perspective, available on YouTube, Blue Chip FM. You can Google us. You'll find us on YouTube. You can also, again, as I mentioned at the beginning, please email us any feedback or questions or comments you have from these episodes, podcast at bluechipfm.com. We're going to continue to pump out insights and perspectives on a weekly cadence. And, you know, we look forward to continuing that trajectory.

[27:14] Dan: Yeah. And the goal of that is to educate. So it's to make sure that we're educating. not only our clients or prospective clients, but the general public, but we want to make sure that we're educating individuals that are interested in these subject matters. So please consider this a resource for education.

[27:33] Matt: And I'm going to put one additional plug. I know Kim's team, Blue Chip Estate is going to be putting out a lot of content. It's amazing the things that I'm continually become aware of since Blue Chip Estate was launched and Kim's in the office now. really great stuff coming your way. So I would just check that out. I mean, those things are awesome. They're very educational and there's going to be a lot coming.

[27:56] Dan: A lot of future discussions surrounding the landmines to avoid or the opportunities within estate planning.

[28:04] Matt: Yeah. There's some just obvious nuances that I keep becoming aware of that just blow my mind and it's going to be interesting stuff.

[28:11] Dan: Right. I look forward to that.

[28:12] Daniel: Well, well said both of you. For those of you tuning in, We look forward to catching up with you again soon.