Prior to retirement, you must set up your investments so that they deliver reliable investment income. Some types of investment income are more reliable than others. When it comes to retirement income, there are many different approaches you can take as to how to use income producing investments.
A good method to understanding different approaches is to break investment income into three categories: predictable, variable, and guaranteed. Each has its pros and cons.
Predictable Investment Income
Interest income from corporate bonds and dividend income from stocks are two good examples of predictable investment income. These sources of income can be relied upon in most circumstances, but they are not guaranteed. You can create a fairly stable source of retirement income by buying interest and dividend paying investments, or by buying mutual funds that own such investments.
Interest income is generated by corporate bonds and mutual funds that invest in corporate bonds, and by certificates of deposit, money market funds, high yield investments, premiums from selling covered call options, and interest received from making private loans, such as what would occur if you sell a property that you own outright and carry the mortgage for the new owner. Interest income, such as that paid by corporate bonds, is taxed at your ordinary income tax rate.
Dividend income is paid out by stocks, mutual funds that own stocks, and by many closed-end funds that utilize a dividend maximization strategy. Dividend income comes in the form of qualified or non-qualified dividends. Most publicly traded U.S. stocks pay qualified dividends. Qualified dividends receive preferential tax treatment, as they are taxed the same tax rate as long-term capital gains, which is a lower rate than the ordinary income tax rate.
Many people plan on retiring, buying a portfolio of income-producing investments, and living off the interest. This may work, but there are several things to keep in mind.
- Income producing investments like stocks can lower their dividend payout rate. When this happens, the share price will drop.
- Bonds can default, or when they mature you may not be able to buy new bonds with an interest rate as high as the previous rate you were receiving.
- Investments may not produce enough income to meet your spending needs in retirement.
- It can be tempting to go for high yield investments. These come with higher risks. In addition, many investments with higher payouts have these higher payouts because with each distribution they are returning some principal.
Many retirees who are not focused on leaving a large sum to heirs can have a more comfortable retirement by creating a plan that allows them to spend some principal in addition to their investment income. This type of plan uses a "total return" approach rather than an approach of only living off the investment income generated.
Variable: The Total Return Approach
One way to create retirement income is to build a total return portfolio consisting of cash, fixed income, and equities. With this approach, you develop an asset allocation model and design your portfolio to match that model. For example, a typical retirement income asset allocation model may call for 5% in cash, 35% in fixed income, and 60% in equities.
The cash and fixed income form the "safe" part of your portfolio. They will generate current investment income in the form of interest. The equities form the growth portion of the portfolio, which allows your future investment income to increase with inflation.
There are withdrawal rules that need to be followed when creating this type of portfolio so that you don't spend too much too soon. The income generated will vary from year to year, but you won't be relying on the actual income the portfolio generates each year. Instead, the portfolio is designed to achieve a target rate of return, and you will set a withdrawal rate that is less than that target return.
If you don’t want to create your own portfolio, you can hire a financial advisor, or use a retirement income fund. Retirement income funds typically follow a total return approach.
The total return strategy is effective if you appropriately diversify your portfolio holdings and re-balance back to your target allocation about once a year. A total return strategy can be layered over a base of guaranteed income. The guaranteed income creates a layer of safety; which can be quite important for peace of mind in retirement.
Guaranteed investment income is exactly what it sounds like; income that is guaranteed by either the U.S. government or an insurance company. Safe investments like certificates of deposit, treasury securities, and fixed annuities are the primary sources of guaranteed investment income.
One risk with using only safe investments is that the interest rates are so low. Safe investments used to pay much higher interest rates, which made it easier to rely on them for investment income in retirement.
There are several ways you can purchase guaranteed income that can be counted on:
- The most common way to purchase guaranteed investment income is by purchasing an annuity.
- You can also delay the start of your Social Security benefits so you get more guaranteed income each year starting at age 70.
- Your employer-sponsored pension plan may allow you to purchase years of service so you qualify for a higher benefit.
- You can purchase certificates of deposit or government bonds that mature each year in an amount that is matched to your projected spending needs that year.
Guaranteed income makes an excellent foundation for a more comprehensive retirement income strategy.
Rather than using only one approach, often the best course of action in retirement is one that incorporates numerous types of investment income strategies.