Abandon Your 401k - Here Is Why

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Includes: FLPSX, MNR, NOBL, SPG, TCO, VBTLX, VTSMX
by: Jussi Askola
Summary

We begin here by making the best case we can for putting no more funds into a 401k than necessary to capture any employer match.

This would open up some opportunities.

We then critique this case and offer some recommendations.

Co-produced with R. Paul Drake

The standard mantra is to always save the maximum allowed amount in tax-deferred vehicles such as 401k, traditional IRAs (“TIRAs”), or Roth IRAs. This is not bad advice, and certainly is better than spending money on vacations that really should go to retirement savings.

Overdoing tax-deferred savings, though, can create challenges. One misses opportunities. In addition, as retirement approaches, it helps to have available funds.

We explore here the opposite alternative of minimizing savings in such environments. We do this first by making the extreme case. In response to that, we offer our more balanced opinions.

Limitations and risks from holding funds in a 401k

Stocks may not be enough: In this age of slow GDP growth, one would also expect overall stock market returns to be low by historical standards. The real return could easily be only half its long-term average of 8% over the next few decades.

Figure 1 shows a very telling chart from an article in Forbes. 20 years are very relevant to practical investing, but not long enough to reliably see the large historical gains that stocks have provided. And as we said, they may not continue anyway.

Chart Data by YCharts

Figure 1. Rolling, 20-year annualized returns of the S&P 500. The year is shown from 1970 to 2019. The return scale goes from 2% to 20%. Source.

Bonds will not be enough: At today’s low interest rates, bonds do not provide enough yield to contribute meaningfully to accumulation of retirement funds. On top of that, when interest rates eventually climb out of their current lows, bond mutual funds will do even worse than they do now. As one example, Vanguard’s (VBTLX), included in their target date funds, was flat during the period of increasing interest rates from 2016 through 2018.

Funds carry additional risks: One can try to beat the market averages by investing in actively managed mutual funds. These limit your gains by being relatively costly. Actively managed funds also make you subject to whatever the active manager ends up doing to make the fund performance look good. Quite a bit of the sell-offs in late 2018 was due to active managers selling low to limit their losses.

Poor, expensive, and limited choices in employer plans: Many employer retirement funds offer a selection of mutual funds oriented mainly toward different takes on common stocks of ordinary corporations. As one example, one retirement account offered through Fidelity has dozens of funds with variations in investments in ordinary stocks, a few funds for investing in bonds, a bunch of funds doing mixtures, and little else. A few funds are available that invest in various specialty areas including real estate. To our eyes, these represent broad ways to invest in sectors that you think will do well. They are not making the tightly-focused selections that a deep value investor would make.

Tax rates will be going up not down: Tax rates today are at their long-term lows over many decades. It seems likely that they will be going up a lot when the political worm next turns. If they increase by 10% of income, this will penalize all your tax-deferred retirement funds by that much upon withdrawal.

You can’t trust the government: Even without any conspiracy theories, those big fat 401k, IRA, Roth IRA, and similar accounts are just sitting there as an easy target for future revenue generation. Even now additional revenue is being generated by changing the rules for taxation of inherited IRA funds. It seems a lot more likely to us that future legislators will attack these funds than that they will try to impose the wealth tax that has been advocated recently. A wealth tax may not be constitutional. Finding out would be a drawn-out mess. It will be much easier to hit the easy target.

Positive reasons to have after-tax funds to invest

You have more choices with after-tax funds: About half of employees do not have access to a brokerage account as part of their employer retirement plan. Even those who do have such access face limitations on the allowed investments. In addition, some investments such as direct investments in private equity or real estate just are not practical from within a brokerage account.

It helps to have cash as you prepare for retirement: It often makes sense to spend hard cash in advance of retirement. You might be establishing investments to produce cash flows you will immediately need. You might be paying off cars or houses to reduce the required income. You might be doing maintenance or renovations for the same reason.

Value investing is easier with after-tax funds: Value investing focuses on buying investments that are cheap relative to their intrinsic value. The approach of buying stocks that are expensive in companies that are growing rapidly is growth investing. The S&P 500 is dominated by the contributions of large-cap growth companies. Growth investing has had a good decade, but value investing has beaten the pants off growth investing in the long run. Figure 2 shows the long-term behavior.

Figure 2. The difference between the returns of high book-to-market stocks and low-book to market stocks (HML) is shown from 1927 through 2017. The long-term average value-stock premium is 4.8%. Source.

While Figure 2 makes value investing look good long term, it shows results from stocks evaluated individually. Houge and Lughran found that value-focused mutual funds do not capture this difference.

Our personal favorite value fund is the Fidelity Low-Priced Stock Fund (FLPSX). It has beaten the pants off S&P 500 index funds over the past 30 years, but not over the past decade.

That said, investing in individual stocks that are enormously underpriced has the potential to produce much larger returns. But this is hard to do in the part of the investment markets that are the focus of intense institutional attention.

You Need More Value-investing Baskets

There are many other value-investing opportunities beyond what few ordinary stocks turn out to do spectacularly well. The most important aspect of these opportunities is that their performance is not strongly correlated with that of the stock market.

Diversification across uncorrelated categories can be your silver bullet. Ray Dalio calls this “The Holy Grail” of investing, and credits much of the success of Bridgewater Associates to having adopted this approach.

At the moment, compelling value-investing opportunities seem particularly strong in REITs, midstream MLPs, and shipping. In each of these cases, there are minefields to avoid and one needs to find expert advice.

Investing in Well-Chosen REITs is One Great Option

At High Yield Landlord, we emphasize deep value investing. We seek out underpriced securities in REITs and other real assets. We believe there are and will be great opportunities.

The CEO of Monmouth Real Estate (MNR) believes that the REIT market remains very inefficient, with frequent opportunities to buy undervalued shares. Quoting from our exclusive interview with him:

"Our main strategy is to identify situations where there is a disconnect between the public and private market valuations. All else being equal, one would expect the public market to be the more efficient one because it is more liquid. However, because the public market represents only about 15% of the total U.S. commercial real estate market, it is often the less efficient one. Today, with the advent of the large, passive, computer-driven fund flows …, these disconnects appear with greater frequency and wider discrepancies than they had in the past."

Modeling Returns from Deep-Value, After-tax Opportunities

We have found that it is consistently possible to find REITs that are undervalued by 30% to 50%. A recovery from such mispricing over five years generates a gain of at least 5% per year.

Examples of companies that seem mispriced today include some of the top shopping-mall companies. The market seems to think that all mall companies are headed for bankruptcy, which is foolish. There is a good chance that Simon Property Group (SPG), yielding 5.5%, and Taubman (TCO), yielding 7%, are both underpriced by a factor of two.

At High Yield Landlord we offer a selection of high yielding REITs that we believe to be underpriced. We cover all sectors of the REIT market. In addition to the mispricing, such companies are growing and paying dividends.

Let’s look at what happens for two cases. In both of them, there is 5% return per year as the stock returns to a sensible price. On top of that, one firm is growing 5% per year and paying a 2.5% dividend, and the other is growing 3% per year and paying a 7% dividend. We compare this with the growth of funds in a TIRA, assuming an average return of 8%, which Figure 1 would suggest might be high for the broad stock market.

The calculation finds the cash-out value for the investments, assuming a 34% income tax rate and a 20% capital gains tax rate. The initial capital is $10,000 in the TIRA and $6,600 in the after-tax cases.

The REIT investments pay taxes on the dividends at the ordinary tax rate, ignoring the current 20% deduction associated with REIT dividends.

Figure 3 shows the results. On the timescales of 10 to 20 years most relevant to retirees, the after-tax investments in deep value REITs do somewhat better. On longer timescales, the difference grows meaningfully.

Figure 3. Cash-out value against time of one-time investments of tax-equivalent funds in deep value REITs or within a TIRA. The low yield case has a price return of 10% and a dividend yield of 2.5%. The high yield case has a price return of 8% and a dividend yield of 7%. Here 60+ refers to withdrawing funds from the TIRA after age 59 1/2. Calculations by author.

Critics will correctly point out that these plots assume that the market does recognize the mispricing within 5 years and that the dividends will not end up being cut. Because such things do happen, these curves may overestimate the outperformance of a portfolio of deep value investments.

The outperformance seen in Figure 3 corresponds to a 2% difference in total return. By avoiding minefields and making good selections, a portfolio of these investments can have small enough losses to outperform, despite the disadvantage of taxability of dividends.

Critique of Abandoning the 401k

Now we discuss what we really think of the above argument. For most people, having only enough in the 401k to capture the employer match is too little. With the possible exception of partnerships issuing K-1s rather than 1099s, it makes sense to do much of one’s investing in a tax-deferred environment.

But the argument above made a compelling case for having some purely after-tax funds as part of one’s portfolio. How much will be an individual decision, but zero is probably the wrong answer.

The amount to keep in after-tax funds should depend in part on whether an investor can make investments in individual securities within a 401k-like portfolio or a Roth. Even then, and even in a Roth, some kinds of direct investments such as private equity will not be feasible within employer plans.

Beyond that, it does not make any sense to invest only in deep value opportunities. These are higher-risk. One never knows when some economic, financial, or regulatory development will have a big adverse effect on some investment sector.

Keeping part of one’s portfolio in traditional stock funds represents sensible diversification. We favor index funds or other broad, inexpensive funds or ETFs for this purpose. Examples include the Vanguard Total Stock Market Index Fund (VTSMX) for the broad market and ProShares S&P 500 Dividend Aristocrats ETF (NOBL) for the Dividend Aristocrats.

All that said, we are fans of large-cap REITs for security and of selected, small-cap REITs for deep value. We believe these belong in every investor’s portfolio, even if it is necessary to use after-tax funds to buy them.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.