By Paul Partridge
One of the most common questions we hear is “What is the best retirement investment?”
Spoiler alert: there is no one, single best investment for retirement accounts. That’s because economic conditions change. Interest rates change. We have to monitor and adjust our portfolio to changing circumstances.
So let’s broaden the question from what is the best investment for retirement to what are the best retirement investments? A sensible investment strategy is to have several different assets in your portfolio so you’re prepared to navigate all different types of market climates.
But first, a question: Can you live solely on interest earned from your bank savings account? Most retirees can’t. We need our investments to produce income to maintain our lifestyle–and pay the bills that continue after we stop working.
That’s why I’ll focus here on the best investments for retirement that produce income. Because after our working paychecks stop, income is what sustains us during retirement.
Here are the most common income producing options:
1. Social Security
Most men and women don’t think of Social Security as an asset. But it absolutely is. It’s a guaranteed income stream that pays you for life.
Many of our clients stand to collect over $1 million in Social Security benefits in retirement. It’s in your best interest to understand and manage this asset.
There are hundreds of ways to collect Social Security, so it pays to talk to an expert who can help you maximize your benefits. Most people just take it starting the day they retire. This can be a costly mistake.
Also, how you take your benefit will impact your spouse if you die first, and vice versa. So it’s worth understanding all your options.
2. Retirement income funds
Retirement income funds are low-maintenance mutual funds for retirees. Typically, they’re diversified in conservative stocks and bonds. The goal of the fund is to produce monthly or quarterly income that can supplement other sources of retirement income.
Most of the big mutual fund companies offer these actively managed funds. There’s usually a required minimum investment, and fund holders pay fees similar to other mutual fund products.
Pros: Men and women who don’t like to spend much time on their investments find retirement income funds attractive. There’s a certain set-it-and-forget-it appeal to them, similar to index funds.
Cons: Retirement income funds are exposed to stock market risk just like mutual funds are. Because people don’t pay regular attention to them, we’ve seen instances where retirees go several months before they realize they’ve had a significant loss. Also, the retirement income is not guaranteed.
Will your investments generate sufficient income to ensure a comfortable retirement?
3. Bonds
When you buy a bond you’re loaning money to a company, government, or municipality. In return, the entity pays you interest on the loan (usually semi-annually) until the maturity date, when you receive a lump sum payment equal to the bond’s face value.
Bonds can be purchased individually or bundled together in mutual funds or ETFs. The interest rate set at issuance remains fixed throughout the life of the bond.
The price of a bond varies according to the bond’s interest and how that rate compares to prevailing interest rates. Generally, when interest rates go down, the price of bonds rises; when interest rates rise, the price of bonds goes down. In this way, bond buyers are subject to interest rate risk—the risk that your bond can lose value when interest rates fluctuate.
One way to hedge interest rate risk is to purchase bonds in a “bond ladder,” a collection of bonds with different maturity dates. Each rung of the ladder represents a different interest rate.
U.S. Treasury notes and bonds are considered among the safest investment options available, with very low credit risk. Treasury notes have maturities between two and 10 years; Treasury bonds have 30-year terms.
Municipal bonds are issued by state, county, and municipal governments and their agencies. The interest you earn is free from federal income tax. You may also avoid state and local taxes if you live in the state where the municipal bonds are purchased, or if you live in a state without state income tax.
Investors concerned about inflation purchase Treasury Inflation-Protected Securities (TIPS). TIPS pay interest plus additional principal tied to increases in the Consumer Price Index.
Corporate bonds usually pay higher interest rates than government bonds because they have greater credit risk. “Junk bonds” are bonds rated below investment grade.
4. Dividend-paying stocks and mutual funds
Dividend-paying stocks are the “Doublemint Gum” of investments—a way to “double your pleasure.” You get the benefits of owning stocks plus the benefits of owning bonds. In other words, you have the potential for both growth and income.
Many large corporations pay dividends on their stocks. A dividend is simply a portion of a company’s net profit that is paid to its stockholders. Dividends are paid on common stock, preferred stock, mutual fund shares, and American depository receipts (ADRs). Companies usually pay dividends quarterly in cash or in shares of stock.
Cash dividends are taxed at the federal, state, and local level—ordinarily at 15%. Stock dividends are not taxed until the shares are sold.
Pros: The potential for income and capital appreciation. Dividend-paying stocks often outperform growth stocks in bear markets, since investors start to favor income over growth.
Cons: Stocks are subject to market risk. Also, corporations are not required to pay dividends to stockholders; they’re paid at the discretion of the company’s board of directors depending on the profitability of the company. So, unlike interest on a bond, a dividend is not automatic.
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5. Rental real estate
Researching, finding, buying, fixing up, renting out, and managing property for income is not for everyone—especially for retirees looking for a relaxed lifestyle. But for those with real estate experience who understand the potential pitfalls, home or apartment rentals can be among the best investments for retirement income.
Pros: Property rentals can produce steady income, tax breaks, and equity growth.
Cons: Being a landlord requires hands-on involvement. Housing prices are cyclical and can drop significantly, as we saw in 2007 to 2010. Expenses include renovation, maintenance, property damage, taxes, advertising, and vacancy rates, to name a few.
6. Real estate investment trusts (REITs)
Real estate investment trusts (REITs) are a type of mutual fund that manages a portfolio of real estate or mortgages to earn profits for shareholders. Equity REITs own real estate directly. Shareholders receive income from rents received, and capital gains when property is sold at a profit. Mortgage REITs lend money to building developers and share interest income with shareholders.
REIT investors typically are seeking income and capital appreciation (as opposed to write-offs). Because REITs are not correlated with the stock market, some believe that REITs are good investments to hold when stock markets are underperforming.
Pros: REITs can provide income, diversification, appreciation, and professional management. In general, real estate is not considered liquid but REITs are, because REITs can be traded daily.
Cons: Commercial real estate prices experience booms and busts. REITs do not provide depreciation write-offs and losses are not passed through to shareholders.
7. Equity index annuity (with a lifetime income rider)
In recent years, an increasing number of retirees are using equity index annuities in place of bonds for the “safe” portion of their portfolio. The main reasons are principal protection and higher potential returns without market risk or interest rate risk.
An equity index annuity (also known as fixed index annuity) is a contract between you and an insurance company. You pay a premium to the insurance company and the issuer promises to make future, recurring payments to you similar to a pension plan.
For a fee, you can add an optional benefit called a rider. The rider provides the certainty of a stable income stream that pays you as long as you live–and as long as your spouse lives if the contract is set up that way. If you die early, the remainder goes to your beneficiaries.
It’s important not to confuse equity index annuities with variable annuities, which are subject to market loss and often have high fees.
Pros: A personal pension plan that protects your money and provides guaranteed income for life—even if you live to 120*. Some annuity companies offer an upfront bonus as well.
Cons: Like a CD, you can’t access all your money during the contract term without a surrender charge (many companies allow for 10% withdrawal per year penalty-free). In exchange for a lifetime income, you give up the opportunity for large upside market gains.
* Guarantees are based on the claims-paying ability of the insurance company.
8. Other options
There are other effective ways to generate income in retirement, including closed-end funds, limited partnerships, covered calls, peer-to-peer lending, and defined outcome ETFs. There’s even a way to use life insurance to produce tax-free retirement income.
But these options are a bit more complicated and require longer explanations than we have room for here.
Summary
Generating sufficient income to assure a comfortable, stress-free retirement is a challenge that’s become even more difficult in recent years. Each of these strategies can be helpful depending upon your risk profile, interest/ability to monitor and manage investments, and your income needs.
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