How to Invest for Retirement With Mutual Funds
Best tips for retirement income strategies
What are the best mutual funds for retirement? It depends on who you are. Retirement looks different for everyone because there are several personal factors to consider, such as your income need, alternative sources of income (i.e. Social Security, pension or part-time job), life expectancy, risk tolerance, and more.
While each scenario is different, there are some general guidelines for all investment and savings needs. For example, people in retirement are typically in a period where they are withdrawing from their life savings, rather than adding to it. Also, as in the years leading up to retirement, retirees need to be careful to select the best investments for their particular needs. These needs are not as focused on growth as they are on preservation and income.
Therefore, investing in retirement is a delicate balancing act, but it can be done successfully if some key points are remembered and smart tactics are applied. The best mutual funds in retirement are those that can keep pace with inflation while minimizing risk and providing returns that increase the chances of your money lasting longer than you.
Before entering retirement you will need to plan for a withdrawal rate. A general rule of thumb is to begin with a rate of 4%. For example, if you need $40,000 per year from your retirement accounts to provide or supplement income, you would need a starting portfolio value of $1,000,000 (40,000 is 4% of 1,000,000).
The 4% rule also makes certain assumptions about average lifespans, rates of return, and inflation. One of these assumptions is that the funds will need to last 30 years from the start of retirement.
For an example of inflation assumptions, let's stick with the $1 million example above. The retiree would withdraw $40,000 in year one of retirement. If their assumption for annual inflation was 3% per year, they would withdraw $41,200 in year two of retirement ($40,000 + 3%, which comes out to $40,000 + $1,200). In year three, the retiree would add 3% to $41,200, and so on.
Some mutual funds, typically categorized as "retirement income funds" or "income replacement funds," are designed with the retiree in mind. In general, the best retirement income funds have a fundamental objective that balances the preservation of assets, income, and growth, prioritized in that order. The highest priority is to achieve positive returns (above 0%); the second priority is to achieve returns at or above inflation; and the lowest priority, which is hardly a "goal", is to grow the assets. This isn't as much of a goal because growth significantly above the rate of inflation would require too much exposure to market risk, which increases the odds of loss of principal. Since avoiding losses is the first priority, a retirement fund is less likely to risk losses for the sake of wealth growth.
Examples of retirement income funds include the Vanguard Target Retirement Income Fund (VTINX), which has a moderate risk profile, and the Fidelity Freedom Income Fund (FFFAX), which has a conservative risk profile. Although past performance is never a guarantee of future results, both funds have trended long-term returns at or above 4% annually on average.
Investing in Balanced Funds
Like retirement income funds, balanced funds are mutual funds that provide a combination (or balance) of underlying investment assets, such as stocks, bonds, and cash. Unlike retirement income funds, balanced funds are typically riskier than retirement income funds.
Also called hybrid funds or asset allocation funds, the asset allocation remains relatively fixed and serves a stated purpose or investment style. For example, a conservative balanced fund might invest in a conservative mix of underlying investment assets, such as 40% stocks, 50% bonds, and 10% money market. You can also find balanced funds that are moderate (medium risk) or aggressive (higher risk), if those better fit your needs.
Investing In Fixed Income Funds
When building a portfolio of mutual funds, the term "fixed income" generally refers to the portion of the portfolio that consists of funds that are relatively low in market risk. Instead of generating income through market swings, investors earn income through interest payments. The rates of return won't be as high as stocks most years, but the overall goal for the fixed income investment strategy is to generate stable and predictable returns.
Since the general fixed income strategy is to generate a reliable source of income, these investment types can include bond mutual funds, money market funds, Certificates of Deposit (CDs), and various types of annuities for the fixed income portion of your portfolio.
Stable income can be generated by more than just fixed income bonds and bond funds. Mutual funds that invest in dividend-paying companies can be part of a smart retirement portfolio. Dividends can be received as a source of income or they can be used to buy more shares of the mutual fund. Most investors who buy dividend mutual funds are usually looking for a source of income—the investor would like steady and reliable payments from their mutual fund investment.
An easy way to invest in dividend-paying stocks is to use a mutual fund, such as T. Rowe Price Dividend Growth (PRDGX), or an exchange-traded fund (ETF), such as the SPDR S&P 500 Dividend ETF (SDY).
Money market funds do not offer high yields, but they can be an important piece of a retirement asset allocation. You will likely use the money market option provided by the brokerage firm or mutual fund company that holds your retirement accounts. You may also shop the best rates on a website like Bankrate.com. Generally, it is best to use municipal money market funds for taxable accounts, such as regular brokerage accounts, and taxable money markets for tax-deferred accounts, such as IRAs. This is especially true for people in higher tax brackets.
A 'CD Ladder' is a savings strategy where a saver or investor buys CDs in increments over time. These aren't mutual funds, but building a CD ladder is similar to dollar-cost averaging with stocks and mutual funds. An investor using this strategy will buy a fixed dollar amount on a monthly or quarterly basis. A saver "builds" a ladder of CDs one rung at a time by purchasing CDs consistently and periodically over a planned timeframe.
The best time to use the CD ladder is when interest rates are low and expected to rise soon. For example, a CD investor expecting a rate hike will not want to tie up all of their savings in one low-rate CD for too long. If interest rates are expected to rise, the CD investor will be able to buy new CDs at higher rates as older CDs in the "ladder" mature. On the other hand, if interest rates are expected to fall, it may be better to buy long-term CDs instead of using the ladder method.
Building a portfolio of mutual funds for retirement is the same as building a portfolio for any other reason—you need a smart and diverse mix that fits your investment objective (which, in this case, is to smoothly transition into retirement with funds that will last for many years to follow). Consider using a Core and Satellite Portfolio structure, which is one that builds around one core holding, such as a retirement income fund, balanced fund, or index fund. The core may represent the largest portion, such as 30% or 40% of your total portfolio. You can then add the supporting "satellites," which may represent 5% to 10% each.
Tax Planning Tips for Retirement Savings
In general, if you expect to be in a higher federal tax bracket in retirement, the Roth IRA is best. If you expect to be in a lower tax bracket, which is most common, the traditional IRA is best. If you will be in the same tax bracket, it doesn't matter which one you use. You may also consider using a regular brokerage account as an alternative. You may also use a combination of all three, and don't forget about your 401(k)! Above all, knowing what federal tax bracket you will be in at the beginning of retirement will be your biggest challenge. It is also important to have the best asset location (knowing which account is best or worst for certain types of mutual funds).
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.