Eventually, you will transition from your prime earning and saving years to a time when you must “live off your acorns.” These will be the years you will draw from your accumulated nest egg. Before you enter this phase, you’ll need to find the best retirement investments, ones that generate regular cash flow. The best retirement income plan for most people uses a strategically selected combination of the following investment types.
Immediate Annuities
Immediate annuities provide guaranteed income immediately (hence the name). They are a form of insurance rather than an investment, but they are still included here because they provide steady cash flow. A ten-year term-certain annuity, for example, buys a stream of income for ten years. Because immediate annuities start paying income right away, they appeal to people who have already retired. They are not for everyone, as the amount you put in is committed for life. Immediate annuities may be advantageous if you need help staying within your spending limits, cannot stick to an investment plan, or have no monthly sources of income besides Social Security.
Bonds
Bonds, individual or bundled-in funds, are loans you give to governments, municipalities, or corporations that then pay you regular interest. The face value of the bond is returned to you when the bond matures. A time-segmented or asset-liability matching investment strategy will use bonds in a bond ladder, a collection of bonds with different maturity dates to match your future cash flow needs. Bonds are a lower-risk option than stocks, but bonds go down in value during times with rising interest rates. If you are holding the individual bonds to maturity, this decrease has little impact on you, but if you are in a bond fund, the share price will drop, and you may lose money if you sell it during that time. We prefer using individual bonds in our retirement income portfolios. Buy bonds not to grow money but for the regular interest income they produce and the structured principal amounts you receive when they mature.
Retirement Income Funds
Retirement income funds are excellent for folks not interested in keeping regular tabs on their portfolio. They are a mutual fund that automatically invests your money in a diversified portfolio of stocks and bonds. The fund’s goal is to produce monthly income. Most people have experience with mutual funds, so they feel comfortable with retirement income funds. Retirement income funds are typically set up so you can access your money anytime. You may see these funds listed with a name like “Target Date 2040,” which means the fund is structuring the investments to align with someone who wants to retire in about 2040. Other funds will have the words “retirement income” in their name, such as Vanguard’s Target Retirement Income Fund, geared towards those already in retirement.
Rental Real Estate
Renting out property for income requires a hands-on approach and, in many cases, more work than you may desire during your golden years. Research and forethought are critical. Before you become a landlord in retirement, consider the rental property expenses you may incur over the time frame you plan to own the property, like maintenance, damage from negligent renters, natural disasters, etc. You also need to factor in vacancy rates—no property remains rented 100 percent of the time. For those with a real estate background, or if you want to put the time in, real estate can be a great source of regular income, but go in with your eyes wide open.
Real Estate Investment Trusts (REITs)
A REIT (Real Estate Investment Trust) mutual fund aggregates real estate holdings (apartment buildings, commercial structures, vacation properties, etc.). For a fee, professionals manage the properties, collect rent, and pay expenses, and you receive the remaining income. REITs can be a good retirement investment choice as part of a diversified portfolio. There are also privately traded REITs, typically offered by advisors or financial salespeople. These REITS are not liquid, meaning your money may be locked up for many years. The exit strategy for private REITS is often to grow large enough to have a public offering or get acquired by a public REIT, or they will eventually liquidate the real estate holdings and return the principal to you. Due to illiquidity, be cautious about private REITs, and if you do invest in them, do so only with small amounts of your total portfolio size.
Variable Annuity with a Lifetime Income Rider
I devote twelve pages in my book Control Your Retirement Destiny to variable annuities. That’s because they’re complicated. In a variable annuity, your money goes into a portfolio of investments you choose. For a fee, you can add an optional benefit called a rider. The rider insures the amount of future income you can withdraw from your portfolio. Variable annuities come in many flavors, and many people who offer them don’t truly understand them. Be cautious – sometimes, I see variable annuities with total fees running about three to four percent a year. Your investments will have to earn back the fees and more for you to benefit.
Closed-End Funds
Closed-end funds are not for newbie investors; they encompass a wide range of investment approaches that may be unfamiliar to laypeople (they overlay stocks and bonds with strategies like dividend captures and covered calls). Income comes from interest, dividends, premiums from selling options like covered calls, or return of principal. Some closed-end funds use leverage (they borrow against the portfolio) —an additional risk employed to buy more income-producing securities so the fund can pay an overall higher yield. Closed-end funds can be a great retirement investment option, as part of a mix, for savvy investors.
Dividend Income Funds
A dividend income fund, like other funds, is a collection of stocks overseen by a fund manager. The dividends you receive come from the dividends paid out by the underlying stocks in the fund. Dividends can rise one year and fall the next. Some publicly traded companies generate qualified dividends, taxed at a lower rate than other income. As such, it may be most tax-efficient to hold qualified dividends within non-retirement accounts (meaning not inside of an IRA, Roth IRA, 401(k), etc.). I caution clients to be wary of funds that advertise high yields – yields higher than average typically come with additional risks.
Total Return Portfolio
A total return portfolio is one of the best retirement investment options when done right. It is not a stand-alone investment but a strategy that uses a balanced, diverse blend of stock and bond index funds that provide retirement income in the form of interest, dividends, and capital gains. The portfolio strives to achieve a respectable long-term rate of return. Along the way, you follow a prescribed set of withdrawal rate rules that will typically allow you to take out 4-7 percent a year and, in some years, increase your withdrawal for inflation. What does “total return” mean? Unlike a Certificate of Deposit, which has a specific interest rate with a total return portfolio, you don’t know what the actual return will be each year. In some years, your investments could be up 14%; in other years, they could be down by 14%. However, over ten years, an appropriately structured mix of investments, such as 60% stock index funds and 40% bonds, has a high probability of earning a 6-7% average rate of return. So, you target that “total” average return rather than knowing the exact outcome each year.
Parting Thoughts
This article is an introduction to income-generating retirement investments. To learn more, listen to the Control Your Retirement Destiny podcast (particularly Episode 5 on Investing) on either iTunes or Podbean. Or watch our recorded webinar, How to Turn Investments into a Retirement Paycheck, on YouTube.
Many of the choices discussed above are investment products rather than financial planning tools. Many financial advisors are salespeople who place too much emphasis on investment selection and investment products and too little on planning. Make sure you have a well-designed retirement income plan in place before you buy any financial product.
