Investment Options For the Soon-to-Be-Retired

August 21, 2013

As the early and late baby boomers get closer and closer to retirement (and in some cases are already there), we receive more and more inquiries about retirement planning, and in particular, distribution planning.  Just recently, I spoke with a gentleman who is within a few years of his retirement date, and he’s done a pretty good job of saving for retirement, but what he is most concerned with now is how to make sure he invests properly throughout retirement so that he generates the cash flow he is expecting to get from his nest egg. There are a number of investment options that may achieve the goal, and each one comes with its own pros and cons.  Here is a look at several different investment options that may be suitable for a retirement investment portfolio:

Immediate Annuity

Annuities have received bad press in the past, usually because of the underlying expenses associated with a variable annuity, but when it comes to retirement income, an immediate annuity may not be such a bad option.  An immediate annuity allows you to give money to an insurance company in exchange for a guaranteed income for the rest of your life. In other words, you exchange the risk of outliving your money for the certainty of a lifetime income, while the insurance company accepts the risk that you may live a long time in exchange for the money you give them now.

An immediate annuity may be favorable to someone that thinks they’ll live beyond normal life expectancy, while someone that thinks their life expectancy is lower than normal may not live long enough to receive the full value of their assets.  (For a scientific estimate of your life expectancy, visit https://www.livingto100.com/.)  Since the monthly income from an immediate annuity is usually fixed, future payments will not purchase as much as they will today.  This is referred to as inflationary risk and is one reason why you don’t want to put too much into an immediate annuity.

Individual Bonds

When you purchase an individual bond, you are essentially lending money to someone else depending on what type of bond you purchase (e.g. corporate, government, municipal).  If the issuer is financially sound and able to make interest payments, individual bonds can be a reliable source of fixed income. But there are certain risks to be aware of.

For starters, if the issuer ever gets into financial straits, your income stream may be disrupted.  For this reason, bonds come with a bond rating, which is kind of like a credit score for bond issuers.  The higher the credit rating, the higher the probability the bond payments will continue, and vice versa.  As you might expect, a bond with a lower rating will have to pay a higher interest rate to attract investors.  If you are using bonds to generate income in retirement, you’ll probably want to stick primarily with investment grade bonds, which are bonds with a credit rating of BBB or higher.

One of the upsides to investing in individual bonds is knowing you will get your money back at some point in the future, assuming the issuer doesn’t run into any financial problems.  This lends itself to another form of risk known as interest rate risk.  Simply put, interest rates in the future may be higher or lower than what they are today, so if you a counting on a certain level of income from your bond portfolio, and interest rates go down in the future, you run the risk that you may not be able to generate as much income when you go to reinvest the proceeds of a maturing bond.  Similarly, money in the future is not worth what it is today, so bonds are also subject to inflationary risk.  You should consider each of these risks carefully before choosing to invest in individual bonds.

Dividend-Paying and Preferred Stock

To hedge against interest and inflationary risk, some investors will purchase stocks.  Stockholders are considered part owners in the company, so when the company generates revenue, the revenue is sometimes passed along to the stockholders in the form of dividends.  Preferred stock is somewhat of a hybrid between stocks and bonds in that the price of the stock is fairly stable and the dividend payout is generally greater.  It doesn’t have the same opportunity for appreciation as common stock, but the tradeoff is usually a higher dividend.  Common stock generally has a lower dividend payout and a more volatile share price, which can be good in an up market but bad in a down market. When putting together an investment portfolio for retirement, it may not be a bad idea to have exposure to these types of equities.

Income Mutual Funds

Mutual funds offer professional management along with diversification and can be a nice alternative to buying individual securities.  Most income funds consist of a combination of dividend-paying stocks and high-quality bonds.  The amount of income that is generated by a mutual fund is represented by its yield, which is stated as a percentage.

For example,  The Income Fund of America®, which is a publicly traded retail mutual fund, consists of approximately 75% stock (mostly dividend-paying) and 25% bonds and cash. The 12-month distribution rate, which reflects the fund’s past dividends paid to shareholders, is just under 3.5% (3.46% of NAV at the time of post).  That means $100,000 invested in this fund over the last 12 months would have generated $3,460 in distributions to shareholders.  Some of this would be from interest earned on bonds, some from dividends from stock, and some from capital gains made when the portfolio manager sold a position.

Depending on the mutual fund, the asset allocation may be static, which means it won’t change over time.  This could be a problem for retirees as they generally get more conservative as they get older.  The income fund mentioned earlier dropped almost 30% in value in 2008, so while the yield may be attractive, the volatility may not.

Target-Date Funds

If you are looking for a simple investment strategy that gets more conservative as you get older but does not require building a customized portfolio using individual securities or mutual funds then target-date funds may be right up your alley.  With a target-date fund, the only decision you really need to make is when you plan to start withdrawing funds from the portfolio, usually at the time of retirement.  Using the three fundamental principles of investing—diversification, re-balancing, and getting more conservative as your risk tolerance decreases—they make life really easy for the hands-off investor.

However, there are downsides too. Target-date funds don’t throw off a lot of income like the other types of investments, so investors will need to sell shares if and when they want to receive money from the portfolio.  Also, target-date funds may have additional management fees, which could make them more expensive than other options.

As you can see, there is more than one way to skin a cat.  In the end, it boils down to how much guaranteed income you want, how much customization you want, how much risk, if any, you can tolerate, and how involved you want to be in the management of your portfolio.  As you answer those questions, your choice of options will become more clear.