01Construct a Total Return Portfolio
One common way to create retirement income is to construct a portfolio of stock and bond index funds (or work with a financial advisor who does this). The portfolio is designed to achieve a respectable long-term rate of return, and 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.
The concept behind “total return” is that you are targeting a 10 to 20-year average annual return that meets or exceeds your withdrawal rate. Although you are targeting a long-term average, in any one year your returns will deviate from that average quite a bit. To follow this type of investment approach, you must maintain a diversified allocation regardless of the year-to-year ups and downs of the portfolio.
You take withdrawals using what is called a systematic withdrawal plan. Be cautious of how you project your potential results—when regular withdrawals are coming out in retirement the sequence of market returns can affect your outcome.
There are many variations to a total return investment strategy such as time segmentation and asset-liability matching, where safe investments are used to meet near-term cash flow needs, and growth-oriented investments are used to fund future cash flow needs.
The total return approach is best used by experienced investors, those who enjoy managing their money and have a history of making logical, disciplined decisions, or by hiring an advisor who uses this approach. When done right, a total return portfolio is one of the best retirement investments you can make.
02Use Retirement Income Funds
Retirement income funds are a specialized type of mutual fund. They automatically allocate your money across a diversified portfolio of stocks and bonds, often by owning a selection of other mutual funds. The investments are managed with the goal of producing monthly income which is distributed to you. These funds are constructed to provide an all-in-one package that is designed to accomplish a particular objective.
Some funds have an objective of producing higher monthly income and may use some principal to meet their payout targets. Other funds have a lower monthly income amount combined with a goal of preserving principal.
With a retirement income fund, you retain control of your principal and can access your money at any time. Of course, if you do withdraw some of your principal, your future monthly income will subsequently go down.
All annuities are a form of insurance rather than an investment. I include them on the best retirement investment list because their purpose is to produce income and that is what you need in retirement.
With an immediate annuity, you are ensuring your future income. In exchange for a lump sum payment, the insurance company is providing you guaranteed income for life (or for some other agreed upon time frame). The guarantee is as strong as the quality of the insurance company that issues it.
There are fixed immediate annuities as well as variable immediate annuities. Some offer income that will increase with inflation, although that means you’ll start out receiving a lower monthly amount.
You can also choose the term of the annuity, such as a 10-year payout, a joint life payout (appropriate if you are married and want income for either of you that may be long-lived) or a single life payout.
Immediate annuities can be a good solution for those who don’t have many other sources of guaranteed income, for those who tend to be over-spenders (meaning they may spend a lump sum of money far too quickly and then have nothing left) and for single folks with long life expectancies.
When you buy a bond, you loan your money to either the government, a corporation or a municipality. The borrower agrees to pay you interest for a set amount of time and when the bond matures your principal is returned to you. The interest income, or yield, you receive from a bond (or from a bond fund) can be a steady source of retirement income.
Bonds have quality ratings to give you an idea of the financial strength of the issuer of the bond. There are short-term, mid-term, and long-term bonds. There are also bonds with adjustable interest rates, called floating rate bonds, as well as high-yield bonds, which pay higher coupon rates but have a lower quality rating. Bonds can be purchased as a package in the form of a bond mutual fund or bond exchange-traded fund, or you can buy individual bonds.
In retirement, individual bonds can be used to form a bond ladder with maturity dates set to match your future cash flow needs. This investment structure is often referred to as asset-liability matching or time-segmentation.
The principal value of bonds will fluctuate as interest rates change. In a rising interest rate environment, you can expect existing bond values to go down. If you plan on holding the bond to maturity principal fluctuations won’t matter. If you own a bond mutual fund and need to sell it to use the funds for living expenses, principal fluctuations will matter.
Buy bonds for the income they produce and/or for the guaranteed principal you will receive when they mature—don’t buy them expecting high returns, or expecting to make a gain on capital appreciation.
05Rental Real Estate
Rental property can provide a stable source of income, but there will be maintenance requirements, and when you own real estate, you will inevitably incur unanticipated expenses. Before you buy rental property you need to calculate all the potential expenses you may incur over the expected time frame you plan to own the property. You also need to factor in vacancy rates—no property will be rented 100 percent of the time.
Investment property is a business, not a get-rich-quick proposition. For those with real estate experience, or those who want to put the time in to make it a business rental real estate can make a great retirement investment.
If you’re not sure where to start, consider reading books on real estate investing, talk to experienced investors, and join a real estate investment club.
Don’t go out and start investing in real estate without doing your homework. I’ve watched people jump on the real estate bandwagon simply because they knew a friend or neighbor who did very well with real estate. Your friend or neighbor may have knowledge or experience that you don’t have. Getting into an investment because someone else was successful with it is not the right reason to do it.
06Variable Annuity With a Lifetime Income Rider
A variable annuity is not the same type of investment as an immediate annuity. In a variable annuity, your money goes into a portfolio of investments that you choose. You participate in the gains and losses of those investments, but for an additional fee, you can add guarantees, called riders. Think of a rider like an umbrella—you may not need it, but it is there to protect you in a worst-case scenario.
Riders that provide income go by many names such as living benefit riders, guaranteed withdrawal benefits, lifetime minimum income riders, etc. Each has a different formula that determines the type of guarantee being provided. Variable annuities are complex, and I have found that many of the people who offer them don’t have a good grasp on what the product does and doesn’t do. Riders have fees, and I frequently see variable annuities with total fees running about 3-4 percent a year. That means to make any money the investments have to earn back the fees and then some.
An annuity is an insurance product. Thoughtful planning needs to be done to determine if you should insure some of your income. If the answer is yes, then you must figure out what account to purchase the annuity in (an IRA or by using non-retirement money), how the income will be taxed when you use it, and what happens to the annuity upon your death.
I rarely see proper planning done before the purchase of variable annuities. Unfortunately, all-too-often the annuity is purchased because someone had cash and a sales person suggested they put their cash into a variable annuity product. That is not financial planning.
07Keep Some Safe Investments
You always want to keep a portion of your retirement investments in safe alternatives. The primary goal of any safe investment is to protect what you have rather than generate a high level of current income.
I recommend all retirees have some a reserve account (an emergency fund). This account should not be included as an asset available to produce retirement income. It is there as a safety net; something to turn to for unforeseen expenses that may come up in retirement.
Also, if you are not sure what to do with your money, park it in a safe investment while you take the time to make an educated decision. Too many people rush to put their money into an investment because they feel like it should not be sitting in the bank for too long. They end up making a rush decision, which is never a good idea.
Making thoughtful, well-informed investment decisions takes time. While you are educating yourself or interviewing advisors it is perfectly okay to park your money somewhere safe. No reputable professional is going to pressure you into making a quick investment decision. If you’re feeling pressured you may not be dealing with someone who has your best interests in mind.
08Income Producing Closed-End Funds
The majority of closed-end funds are designed to produce monthly or quarterly income. This income can come from interest, dividends, covered calls, or in some cases from a return of principal. Each fund has a different objective; some own stocks, others own bonds, some write covered calls to generate income, others use something called a dividend capture strategy. Be sure to do your research before buying.
Some closed-end funds use leverage—meaning they borrow against the securities in the fund to buy more income producing securities—and are thus able to pay a higher yield. Leverage means additional risk. Expect the principal value of all closed end funds to be quite volatile.
Experienced investors may find closed end funds to be an appropriate investment for a portion of their retirement money. Less experienced investors ought to avoid them or own them by using a portfolio manager who specializes in closed-end funds.
09Dividends and Dividend Income Funds
Instead of buying individual stocks that pay dividends, you can choose a dividend income fund, which will own and manage dividend paying stocks for you. Dividends can provide a steady source of retirement income that may rise each year if companies increase their dividend payouts—but in bad times, dividends can also be reduced, or stopped altogether.
Many publicly traded companies produce what are called “qualified dividends” which means the dividends are taxed at a lower tax rate than ordinary income or interest income. For this reason, it may be most tax-efficient to hold funds or stocks which produce qualified dividends within non-retirement accounts (meaning not inside of an IRA, Roth IRA, 401(k), etc.)
Be cautious of dividend paying stocks or fund with yields that are quite higher than what appears to be the average rate. High yields are always accompanied by additional risks. If something is paying a significantly higher yield, it is doing so to compensate you for taking on additional risk. Don’t invest without understanding the risk that you are taking.
10Real Estate Investment Trusts (REITs)
A real estate investment trust, or REIT, is like a mutual fund that owns real estate. A team of professionals manages the property, collect rent, pay expenses, collect a management fee for doing so, and distribute the remaining income to you, the investor.
REITs may specialize in one type of property, such as apartment buildings, office buildings, or hotels/motels. There are non-publicly traded REITs, typically sold by a broker or registered representative who receives a commission, as well as publicly traded REITs which trade on a stock exchange and can be bought by anyone with a brokerage account.
When used as part of a diversified portfolio, REITs can be an appropriate retirement investment. Due to the tax characteristics of the income REITs generate, it may be best to hold this type of investment inside a tax-deferred retirement account such as an IRA.
If you've made it to the end of this list, congratulations! Learn all you can, and remember, it makes the most sense to choose your retirement investments as part of an overall investment plan. Investments are best chosen to work together—not as individual solutions. All 10 options presented can be mixed and matched and used as part of a plan.