The Best Aggressive Investment Options in the CT State 457 Plan
The Connecticut 457 plan does not provide a wide array of fixed-income options as there are only five available. Fortunately, there are several equity options that cover multiple asset classes, company sizes, and portfolio styles. Which means that you have the ammunition required to create a well balanced portfolio that will accommodate your investment needs. For this reason, I went through the options to determine which I believe will perform well in 2023 and beyond. If you have a 457 plan and are interested in my analysis, then I’d highly suggest you read this blog!
Key Takeaways:
Overview of the CT 457 Plan
What is My Risk Profile?
Determine Your Asset Allocation
Growth vs. Value vs. Blend
Should You Include International Securities?
What About Domestic Real Estate Securities?
The Best Aggressive Investment Options in the CT 457 Plan
Rollover into an Individual Retirement Account (IRA)
Overview of the CT 457 Plan
The State of CT offers different retirement plans for each type of employee. For example, the 403(b) is offered to employees who work for the State education institutions or hospitals. To contrast, the CT 457 Plan is available to any employee performing services for the State. The 457 plan is a defined contribution plan which means the employee bears the investment risk, as he/she contributes to the account and their employer matches up to a certain amount. The employee will make contributions pre-tax which is typically automatically deducted from their pay stub and will be subject to income tax when the money is withdrawn in the future.
The contribution limit is $22,500 with a $7,500 catch-up clause for individuals age 50 or older in 2023. The 457 plan can be used in confluence with, for example, the 403(b) plan that I mentioned above as State teachers or Hospital workers are allowed to open and contribute to both a 403(b) and 457 plan. The other advantage is that there is no early-withdrawal penalty for those who withdraw funds before they are 59 and a half. In a 403(b), 401(k), IRA, or Roth IRA, there is a 10% penalty for early withdrawals. For these reasons, I would suggest that anyone eligible for a 457 plan should go ahead and open one.
What is My Risk Profile?
There are many reasons to invest in aggressive investments. However, there are several things to consider before doing so due to the risky nature of equity investments. For this reason, anyone can invest conservatively, but only those who meet the criteria should invest aggressively. If you are unsure about your suitability, then you should start with your risk profile which is typically composed of a few things. This would include your overall attitude towards risk, your investment horizon, and your income.
Let’s begin with an example. If you are 30 years old, then you have a long investment horizon (until retirement) and should receive a salary each year leading up to it. Therefore, this person can take excess risk in their portfolio as they have the capability to wait for their portfolio to rebound if caught in a large drawdown or extended period of downward market movement. On top of that, they would be able to average down using funds from their salary, allowing the downturn to improve their cost basis.
To contrast, the excess risk would likely not be suitable for an individual that is 60 and preparing to retire. In Connecticut, the average retirement age is 65 which makes sense because that is when Medicare begins. Therefore, their investment horizon would be about five years and they would only have another 5 years of income from their job. In addition, many pre-retirees work a lesser paying, lower stress potion in the few years leading up to retirement so the income may be limited. In this situation, the retiree should not take on excess risk as capital preservation should be the focus. If there was a severe market downturn or period of downward market movement then it could be detrimental to their retirement portfolio as there may not be enough time for the investments to rebound.
Charles Schwab offers a Free Investor Profile Questionnaire if you are interested.
Determine Your Asset Allocation
Now that we have an idea of your risk profile, we can use that information to help determine your target asset allocation. A common rule for asset allocation is that you should hold a percentage of equities that is equal to 100 minus your age. Therefore, using that model a 60 year old individual should have a portfolio allocation of 40%. Personally, I don’t agree with this method. If you are in a decent financial standing and want your portfolio to provide income each year in retirement, then I would suggest a 60% equities and 40% fixed income portfolio.
Of course, this is all dependent on your own unique situation and blanket (general) advice will not apply to everyone. The role of equities within your portfolio is to help grow your portfolio. As companies grow, their stock prices appreciate leading to gains in value for shareholders like you and me. Retirement plans like the 457 plan will not allow you to purchase individual stocks but will consist of ETFs or Mutual Funds which hold several underlying stock positions.
The fixed income positions in your portfolio are designed for conservation of principal. However, on top of keeping your money safe, they also provide a yield. That said, the degree of safety ranges as not all fixed income products are created equally. A common investment in a retirement plan is a stable value fund. Stable value funds hold insured bonds that protect investors from a loss in capital or yield. The other fixed-income product found in retirement plans are bond funds which hold several underlying bond positions. Unlike the stable value fund, these bonds are not insured which means your initial investment can increase/decrease and yields will vary as well.
Charles Schwab has a useful reading that describes how individuals should allocate their retirement portfolio.
Growth vs. Value vs. Blend
The next area of investment that we are going to cover is the styles of funds. You will see in your retirement plan that there are Growth, Value, and Blended funds. This could be seen in the same of the fund, or the section title in your list of investment options. These funds are created with different goals in mind, so you want to make sure that the fund you are purchasing matches your investment goals.
The first style that I am going to cover is Growth. These funds are designed for capital appreciation, basically the opposite of capital preservation. The underlying stock positions will consist of companies that have not yet reached their maturity phase and are still poised for growth. These funds are typically riskier for shareholders as retained earnings are reinvested with the goal of further growing the company. This is the riskiest of the three investment styles, and a good example of a stock you would find in a growth fund is Tesla (TSLA).
The next style is Value funds. Value funds are commonly composed of more mature companies that have consistent cash flows and do not require large investments towards growth. Instead of retained earnings being reinvested for growth, these companies would rather pay out a portion of this money to shareholders called dividends. If the Value fund is within your retirement account, then you should have the dividends reinvested, meaning the funds are used to purchase more shares within your account. Meanwhile, if you hold value funds in a taxable account, then you can decide whether you want the dividend sent to you as a check or automatically reinvested in your account. An example of a value stock would be Honda Motor (HMC).
Lastly, we have Blend or Blended funds. These funds are composed of a mixture of Growth and Value stock positions to create a neutral portfolio that aims for both growth and dividends. Each year, analysts predict whether Growth or Value funds will perform better. They have more information than we do, and yet they still struggle to make correct predictions. For this reason, I prefer to use blended funds in my client accounts with a “best of both worlds” mindset. That said, if you want to grow your portfolio with riskier stocks or collect dividends on more established (safer) stocks then it could make sense to pick one over the other.
For more reading about Value vs. Growth stocks, you should check out Investopedia’s article from 2022 describing the pros and cons of each:
Should You Include International Securities?
The ideal allocation of international securities within an investment portfolio is one of the larger controversies in portfolio management. Over the past ten years there has been no competition, the United States stocks have well-outperformed international stocks. For this reason, certain investment managers either keep the allocation around 10% or do not include them at all.
To contrast, Vanguard recommends that at least 20% of your overall portfolio is invested in international stocks and bonds. They go on to claim that you should have about 40% of your stock allocation and 30% of your bond allocation invested in international. Which means that if you had a target allocation of 60% equity and 40% fixed income then you should invest 24% of your portfolio in international equities and 12% into international bonds. Personally, this advice seems too optimistic this advice seems misguided as 2022 was one of the first years that international securities outperformed domestic in a long time. But I do believe that at least 10% of your portfolio should be invested in international securities and bonds.
You can read further about Vanguard’s international investment strategy here.
What About Domestic Real Estate Securities?
Personally, I prefer to physically own real estate property rather than Real Estate funds. My issue with real estate mutual funds, like the ones found in retirement plans, is that they invest primarily in Real Estate Investment Trusts and Real Estate Operating Companies. REITs were all the rage a few years ago, but since their gain in popularity they have performed poorly. That said, let’s review the benefits of investing in real estate.
There are many benefits to including real estate in your portfolio. A few of these reasons are recurring income, diversification, and tax-benefits. Several real estate products earn their income through rent which is a predictable cash flow. This fact allows real estate investments like Real Estate Investment Trusts (REITs) to pay out sizable dividends to shareholders. Additionally, you can improve the diversification of your portfolio because the typical stock and bond investments have a low correlation with real estate. If stocks and bonds are losing value, real estate could still perform strongly.
The next benefit of investing in real estate is the associated tax-benefits. These tax-benefits vary for physical real estate owners and those who own a real estate mutual fund. If you physically own a rental property, then you can use the associated depreciation to offset your rental income and lower your tax bill. To contrast, the tax-benefits for real estate mutual funds are a little different. First, REITs do not pay corporate income taxes, which allows investors to receive larger dividend payments. The second benefit is that investors can deduct 20% of their dividends earned using the qualified business income deduction.
Now the question, should you include real estate mutual funds in your retirement portfolio. Like every investment, it really depends on your own situation. There are plenty of reasons to invest in real estate as we covered below, but unfortunately the performance has large deviations. In some years you will see +30% and then in others you will see -24% so these real estate positions must be treated as risky investments. If you are risk averse or already own rental properties, then it would make sense to keep your real estate allocation limited. To contrast, if you have zero real estate exposure or are interested in the large potential gains then you could allocate extra towards it. Generally, I would recommend an allocation of less than 10%.
The Best Aggressive Investment Options in the CT 457 Plan
The aggressive investment options in a 457 plan are going to be the equities (ETFs or Mutual Funds), international, and real estate securities. The ETFs/Mutual Funds are divided into categories based on the size of the underlying funds (holdings within the mutual fund or ETF). Large-cap stocks are the largest and typically the safest with a market capitalization between $10 billion and $200 billion. Mid-cap stocks are the next safest investment, and these stocks have a market capitalization between $2 billion and $10 billion. Lastly, the small-cap stocks are the riskiest positions, but also boast the largest potential return and their market capitalization fall between $250 million and $2 billion.
Let’s start with the large-cap investment options. The two funds that I believe have the most potential is the Vanguard Institutional Index Fund Institutional Plus Shares (VIIIX) found under Blended funds and the TIAA-CREF, Large-Cap Growth Index Fund Institutional Class (TILIX) found under the Growth funds. The Vanguard Institutional Index Fund Institutional Plus Shares (VIIIX) has had the best past performance out of the three blended funds. The 10, 5, and 3 year annualized returns are the highest of the group while the fund boasts the lowest expense ratio at 0.02% per year. The TIAA-CREF, Large-Cap Growth Index Fund Institutional Class (TILIX) has similar attributes as it has outperformed the other growth fund under each time frame while having the lower expense ratio of 0.05%.
Now let’s review the mid-cap investment options. The best performing fund over the past 10 years is the T. Row Price Diversified Mid Cap Growth Fund I Class (RPTTX). Unfortunately, it is not a low cost fund as the expense ratio is 0.65% per year. At Morrissey Wealth Management, we prefer to invest in low-cost index funds, so another great mid-cap investment option is the Vanguard Mid-Cap Index Fund Institutional Shares (VMCIX). This fund has had similar performance to RPTTX, but the expense ratio is 0.04%. Therefore, you have two options. If you are willing to take on excess risk then I’d recommend RPTTX, but if you want the low-cost long-term option then VMCIX could make more sense.
Next, we will cover the small-cap options. There are only two small-cap funds, the Vanguard Explorer Fund Admiral Shares (VEXRX) is a small-cap growth fund while the TIAA-CREF Small-Cap Blend Index Fund (TISBX) is a small-cap blend fund. The Vanguard fund has had significantly better performance other the past ten years, but the expense ratio is 0.34%. If you are more concerned with capital preservation and lower fees, then you could consider the TIAA fund which has a 0.06% expense ratio.
The plan includes two international funds as well. One is a large-cap blend fund called the TIAA-CREF International Equity Index Fund Institutional Class (TCIEX) and the other is a large-cap growth fund called the American Funds EuroPacific Growth Fund Class R-6 (RERGX). The performance of these two funds over the past 10 years has been similar, which means the next focus should be on the expense ratio and risks. TCIEX has an expense ratio of 0.05% per year and carries less risk as a blended fund. Therefore, if you were interested in having international exposure, then I’d invest in the TIAA-CREF International Equity Index Fund Institutional Class (TCIEX).
Lastly, there are two domestic real estate funds. These include the DFA Real Estate Securities Portfolio Institutional Class (DFREX) and the Vanguard Real Estate Index Fund Institutional Shares (VGSNX). The performance and expense ratios of these funds are very similar. However, the performance was slightly better in DFREX while VGSNX has a lower expense ratio. Therefore, if you are focused on excess returns then I’d suggest DFREX. While if you want to minimize the expense ratios of your holdings, then VGSNX could make sense.
Rollover into an Individual Retirement Account (IRA)
The final thing that I want to mention is the benefit of rolling over your 457 plan when eligible. The Connecticut 457 plan has solid investment options, but the list is restricted. The plan does not allow you to purchase individual stock positons, commodities, emerging market funds, etc. The solution ito this issue is a rollover into an IRA that does not have restricted investment options which will allow you to create a portfolio that best suits your profile.
Unfortunately, you must meet specific criteria to rollover your account. There are two main reasons, either you have separated from State employment or you are older than age 59 and a half. If you are eligible, the first step you need to do is open an IRA with a trustworthy custodian. Then you can simple fill out the rollover paperword and the rest should be taken care of. If you are interest in rolling over your CT State 457 plan or would like to further discuss the aggressive investment options then I’d recommend you schedule a consultation. You can sign up for my free consultation using the link. During the call, we can determine whether your needs match my expertise.
If you are interested in reading related blogs, then I would recommend:
“The Most Conservative Investment Options in the CT State 457 Plan”
“What Connecticut State Employees Should Do With Extra Vacation Days”
“How to Calculate the Cost of Living Adjustment for CT State Employees”
