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  • Mark Fonville, CFP®

The Best Investments for Income in Retirement


Best investments for income in retirement

You've worked hard for your money. Now it's time to enjoy it.

Finding the best investments for income in retirement will be paramount to your success.


Even with a investment review cheat sheet, making your money last won't be easy.

According to the most recent longevity data from the Social Security Administration, a 50-year-old male can expect to live another 30 years, while a 50-year-old female can expect to live for 33 more years.

At age 60, men and women can expect to live another 22 and 25 years, respectively. These statistics highlight the jarring reality that retirees will most likely need to sustain income for decades.

Reaching retirement is a significant milestone and also a time of powerful financial and investment changes. One of those changes is converting your growth portfolio into an income portfolio.


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So, what are the best investments for income in retirement? Here's what we'll cover to help answer that question:

Overview





The best investments for income in retirement should help you create sustainable income for the rest of your life.


Your investments should also help you maintain financial security.

To accomplish these goals, you’ll need to construct an investment portfolio with different investments, each working to complement the other. Unfortunately, there is no single investment that will solve your retirement income problems.


After helping people invest for nearly twenty years, I know this from experience.

The good news is that once you know what you're trying to accomplish, finding the best investments gets a little easier.


While every situation is different, each investment you select should serve as a building block to improve your overall portfolio in the five areas below:


  • Risk

  • Return

  • Cost

  • Taxes

  • Income


For example, ask yourself the following questions:


  • How does the investment I'm considering help me better manage the risk in my portfolio?

  • How does the investment I'm considering help me get the returns I need?

  • How does the investment help reduce my costs?

  • Is the investment tax efficient?

  • How does the investment help my portfolio create the income I need to maintain my lifestyle?


Remember, no investment is perfect for all situations. But when combined together, the best investments for income in retirement should create a total portfolio that helps you create sustainable income for life.


Understanding Diversification

In your working years, growing your portfolio may be a primary concern. But when you retire, your attention often turns toward reducing risk and making your money last.

That’s where portfolio diversification* comes into play.

Diversification is one of the most critical elements of an investment strategy. It is a foundational building block of any investment plan.


Whether you’re a novice investor or in your retirement prime, diversification is a mainstay for any long-term portfolio.

So, when picking investments for retirement, diversification is a telling factor.

Why does diversification hold so much value?

Diversification seeks to manage your portfolio’s exposure to risk and has the potential to increase your portfolio's efficiency.

An efficient portfolio has the potential to do two main things:


  • Increase expected returns

  • Reduce fluctuations in overall portfolio value


While not guaranteed, proper use of diversification may accomplish these two objectives relative to a portfolio that is not adequately diversified.

For example, did you know that all stocks from 1994 to 2020 had a compounded average annual return of 8.2% per year? However, if you exclude the top 25% of performers each year the return drops to -4.7%!


The Best Investments for Income in Retirement - Benefits of Diversification

That’s why diversification matters. If you aren't diversified enough, evidence suggests that there is a high probability that you can end up owning the worst performers.

When it comes to diversifying your investments for income in retirement, remember that your fundamental risk is having too much exposure to a single investment.

Before retirement, you have time to make financial adjustments or work a little longer if something happens.


Your golden years don’t offer the same flexibility.

What factors make a portfolio diversified?

There are many factors that contribute to a well diversified portfolio including:


  • # of holdings

  • Exposure toward stocks, bonds, real estate, or guaranteed income sources

  • Exposure toward value companies and growth companies

  • Exposure toward large and small companies

  • Exposure to guaranteed income sources such as pensions or social security.


In practice, the best investments for income in retirement should contribute toward your overall game plan.


When it comes to creating a retirement income portfolio, the sum of the parts is always more powerful than the individual components by themselves.

In practice, we believe a diversified portfolio should contain thousands of stocks and bonds across many industries and sectors.

Owning just a handful of stocks simply doesn’t cut it.


You can achieve a diversified portfolio by being deliberate in your asset allocation (mix of investments) and selecting a mix of index funds, exchange-traded funds (ETFs), mutual funds, stocks, and bonds.


Remember, your asset allocation should also consider your retirement age, risk tolerance, and retirement goals.

Here is an example of an asset allocation we actually use with clients at Covenant Wealth Advisors.


The Best Investments for Income in Retirement - Example Portfolio Composition

This portfolio may be great for some investors. But it may be terrible for others. It all depends on your personal goals, risk tolerance, tax situation, need for income, and more.


Go global

You should also pay particular attention to geographic diversification. International diversification should always be considered when selecting the best investments for retirement income.


Why?

Investors have a well-documented tendency to heavily invest in companies that are geographically close to them. This habit is called home-country bias.


Unfortunately, "home bias" is as harmful to your retirement income portfolio as concentrating too much in any one industry or sector from a risk perspective.

To consider how undiverse a portfolio composed primarily of investments in the United States is, just consider the size of the non-U.S. equity market.

The chart below shows the world market capitalization of stocks across different countries.

As illustrated in the chart below, the United States represented 57% of the global equity market capitalization in 2020. That’s certainly a lot for one country, but the other 43%, nearly half the opportunity, lies outside the United States!


The Best Investments for Income in Retirement - World Market Capitalization of Stocks

That means the best investments for income in retirement may also be located beyond U.S. borders.

Remember, too, that the power behind diversification lies in how the investments relate to each other when creating a complete portfolio.

When one investment lags, will there be another investment in the portfolio to pick up the slack?

The Best Investments for Income in Retirement - Diversification Smooth Out the Bumps

If all of your investments are going up at the same time, by definition, you aren't diversified! When one investment "Zigs" the other should "Zag".

The point here isn’t to try and guess which investment will outperform another in a given year—you simply can’t. The point is to remember proper diversification and to hold broad exposure to many parts of the global economy.

Now that you have a firm understanding of why diversification is so important in retirement, let’s talk about tax efficiency.

Double Down on Tax Efficiency

When it comes to choosing the best investments for retirement income, don’t forget about taxes!

Once you reach retirement, managing your taxes is one of the best ways to get more out of your savings and increase their longevity.

The investments you select, your withdrawal plan, and even timing strategic decisions like Roth conversions or tax-loss harvesting can all affect how much you will owe in income taxes.

The secret?

Keep taxes top of mind from beginning to end. Proactive tax planning is all about balance, so try to keep a multi-year perspective because sometimes it makes sense to increase your taxes one year to reduce them even more, the next.

Your retirement income plan should consider tax-efficient investments.

After all, it’s how much you earn on an after-tax basis that determines your true return in the first place!

Now that you know the key considerations for a sound retirement income portfolio, let’s dive into the best investments for income in retirement.


1. ETFs and Low-Cost Index Mutual Funds


ETFs make excellent retirement investment vehicles for creating a portfolio designed to provide you with adequate income.

There are several reasons why ETFs are so valuable.

ETFs generally have lower costs.

Investment fees can reduce your total returns over time, so managing your fees should be a top priority both before and during retirement.


ETFs are designed to operate more efficiently than comparable mutual funds, resulting in lower costs on average.


These costs include the administrative expenses of running the fund, management fees, trading costs, and fees associated with marketing the fund.

ETFs are generally tax-efficient.

The ETFs structure also makes them extremely tax-efficient. Compared to mutual funds, it’s much easier to control your capital gains with an ETF.

Why?

Because ETFs do not pass capital gains through to individual investors. Instead, you only incur capital gains on ETFs when you sell them.


This allows you to push more of your capital gains into favorable long-term tax brackets and time the realization of gains to take the best advantage of offsetting capital losses.

ETFs offer better liquidity.

Mutual funds can only be redeemed once per day at their net asset value, which must be tallied after the market closes. ETFs, however, trade just like stocks. This allows you to reallocate your portfolio in real-time rather than once a day.

ETFs are great for diversification.

For most indexes that exist, you can find at least one ETF that tracks it. This allows you to quickly build a portfolio with the broadest diversification.

2. Immediate Annuities

The Best Investments for Income in Retirement - Definition of Annuities

In the finance world, there is a lot of confusion about annuities. That’s because there are many different types, each with different purposes, and they often get lumped together.

In my experience, I’ve found that many annuities simply don’t make sense from a cost perspective. Additionally, they often tie up your money for years on end.


Unfortunately, financial advisors often recommend them because of the fat commissions they receive after selling them to unassuming investors. Annuities can be very expensive, complex, and many have withdrawal penalties.


For the most part, I don’t like annuities!

However, not all types of annuities are unnecessarily complex and expensive.

One particular type of annuity that you may consider as you allocate your investments for retirement income is an immediate annuity.

When used appropriately, immediate annuities can bring a steady stream of income to you and your family.


Unlike other annuities where you pay an insurance company and benefits are distributed at a much later date, you receive the benefit of an immediate annuity “immediately” after you purchase the product.

In simple terms, with an immediate annuity, you give an insurance company a sum of money, and in exchange, that company provides a guaranteed income stream.

Breaking down immediate annuities

There are some decisions to make about your immediate annuity.

First, you’ll have to decide on the type of payment you want to receive.


There are two basic types of immediate annuity payments: fixed and variable.

Fixed payments are a set dollar amount that doesn’t adjust over time. Variable payments will fluctuate based on the performance of some underlying benchmark such as an index.

Depending on the company issuing the annuity, you may be able to choose an inflation adjustment option, but the tradeoff will be a lower starting payout.

Another choice you’ll have to make is the period over which the annuity will provide an income stream. You can choose to have your annuity payout over your lifetime or for just a set number of years.

A lifetime payment option makes sense when you want to guarantee a certain minimum amount of income for the rest of your life. A fixed period called a period certain option helps bridge a known time span such as the time between retirement and the start of a pension benefit.

Shopping for immediate annuities

As you shop for an immediate annuity, you’ll be comparing payout rates on different contracts.

Pro tip: Don’t confuse the payout rate on an immediate annuity with a rate of return on investment. They are not the same thing.

For example, a 5% payout on an annuity that costs you $100,000 will provide you with a $5,000 payment, but that is partially a return of the principal amount.

The most important thing to remember about annuities is that they are insurance products.

For the most part, insurance products are designed to protect, not invest.

An immediate annuity is a supplementary tool for creating income in retirement, not for growing your retirement account.

An annuity is suitable for ensuring that you have a known amount of income coming in. The tradeoff is that you may lose the flexibility you would have if you kept that money invested in stocks, bonds, and ETFs.

An immediate annuity may be a good option for you if you need to guarantee a portion of your income.

But, they aren’t great for everyone, which is why you should get professional advice.


3. Individual Bonds and Bond Funds

Bonds are one of the primary asset classes of investments, so most investors are familiar with them.


But there is much more to using bonds for retirement income than simply deciding on an allocation and receiving interest payments.

Interest payments are nice and can certainly be a part of your income plan, but you can get a lot more out of your bonds with specific strategies designed to optimize your retirement income, manage taxes, and provide balance and liquidity in your retirement portfolio.

Some investors question bonds because interest rates are so low as of 2021.


Don’t fall into the trap of pursuing bonds for their yield alone. High-yield bonds, for example, have a high risk of default. In fact, we almost never recommend them to clients nearing retirement due to their high risk.


The right bonds can be a powerful contributor to creating a stream of income in retirement.

The various types of bonds

Like annuities, there are different types of bonds and the differences matter.


Corporations, state and local governments, and the U.S. Treasury all issue bonds. Some federal agencies, such as the FHA also issue bonds.

  • Companies issue corporate bonds to finance their operations, research, and expansion. The interest you receive from corporate bonds is taxable, and the interest rate will usually be a little higher than comparable bonds of other issuers.


  • State and local governments issue municipal bonds. These are often referred to in short as muni bonds. While the stated interest rate on muni bonds will be lower than comparable corporate bonds, it generally received tax-free. Because of that, the net income you keep could be higher on a muni bond relative to a taxable bond depending upon your federal and state tax rates.


  • U.S. Treasury bonds are backed by the money-creating authority of the Federal government, making them the safest form of debt security. The interest is also not taxable at the state and local levels.

Each type of bond can be purchased individually or through an ETF or mutual fund.

In addition to the interest income that bonds provide, they also serve to protect your principal investment and provide a basis for rebalancing your portfolio to take advantage of market volatility.

Let’s take a look at how this concept works.

Bond strategies to consider

When equity markets fall, your portfolio becomes mismatched. The more stable bond position in your portfolio, then, will need to be reallocated to reinstate your portfolio back to your appropriate allocation.


This shift naturally causes you to buy stocks when prices are lower without timing the market.

One strategy involving bonds that that some investors consider for retirement income planning is the bond ladder. With this strategy, you invest in bonds with staggered maturities so that a known amount of principal matures at regular intervals.

For example, you may build a bond ladder to have bonds that mature every six months for ten years. This strategy is a way to guarantee that you have a certain amount of liquid savings available without having to worry about selling equities in a lousy market.

Over the long term, the total return you receive from bonds has a higher likelihood of generating lower returns than what you’d get on stocks.

But that isn’t the point of buying bonds.

Three fundamental reasons drive the value for owning bonds in a retirement portfolio:


  • Short-term, high-quality bonds are generally more stable than stocks.

  • Bonds provide a source of income, tax-free in some cases.

  • Bonds may provide a source of liquidity for major purchases in retirement, especially when the stock market is down.

Bond ladders may be great for some investors.


But, at Covenant Wealth Advisors we prefer using well-diversified mutual funds or ETFs for most of our clients. The reason is that it’s less expensive to purchase bonds through a mutual fund or ETF, and it’s easier to diversify the holdings.

Here are some examples of low-cost, well-diversified bond fund investments:


  • Fidelity Short-Term Bond Index (FNSOX)

  • DFA Five-Year Global Fixed-Income Portfolio (DFGBX)

  • iShares S&P Short-Term National Muni Bond ETF (SUB)


4. Real Estate Investments


Real estate is an asset class with unique characteristics that make it an attractive investment for retirement income. Let’s examine three special types of real estate investing along with their benefits and drawbacks.

Rentals

Rental real estate provides steady cash flow in the form of rent that will generally keep pace with inflation over long periods.

It’s not risk-free, however.

Tenants do not always pay rent on time, and you may have vacancies between tenants. You are also on the hook for damages and property updates, among other variables.


If rental real estate is part of your income plan, make sure to account for these periods of lost rent in your projections.

REITs

Not everyone is interested in being a landlord in retirement. Real estate investment trusts, or REITs, allow you to invest in real estate without the need to manage the property and collect rent.

REITs pull money together from many investors to invest in many properties, similar to how a mutual fund pools investor money to buy stocks.

Not only do REITs handle all the administration and management required, but they are legally obligated to pay out at least 90% of their income to investors.


REITS can be purchased through well diversified mutual funds and ETFs including:


  • DFA US Real Estate Securities Portfolio (DFREX)

  • Vanguard Real Estate ETF (VNQ)

  • iShares US Real Estate Index (IYR)

Reverse Mortgage

If you own your home, then a reverse mortgage provides you with a way to access the equity you have built. A reverse mortgage is a loan that homeowners age 62 or older can take to access the value in their home. That value can be received via a lump sum, fixed payments, or a line of credit.

Unlike a traditional mortgage, you don’t make regular payments on the reverse mortgage. The loan must be paid in full once you move out of the house or pass away.

As the name describes, with a reverse mortgage, your lender sends you a monthly payment from your home’s equity.

While flexible and convenient, a reverse mortgage effectively builds your debt balance up over time rather than paying it down.

Should you use a reverse mortgage?

Before you decide, you need to understand that it can be expensive and risky. You will have to pay fees associated with the reverse mortgage, and interest accrues on your debt balance.


The origination fee alone could cost you as much as 2% of your home's value, and then there will be ongoing mortgage insurance.

A reverse mortgage could also cause you or your heirs to lose the home. If you fail to upkeep your taxes and insurance, then the bank can foreclose on you. If your heirs cannot pay off the debt balance when you pass away, then the bank will sell the home to pay off the debt. Any remaining equity, if any, may go to your heirs.


There are some powerful tax advantages to reverse mortgages as well.


Reverse mortgages are not an investment per se, but they can be a great addition to your overall retirement income strategy If used the right way.

5. Dividend Paying Value Stocks


Value stocks can often produce dividends for retirement income. You can either invest in dividend stocks directly or through a mutual fund or ETF.

What are value stocks?

Value stocks are companies that have low prices relative to other fundamentals such as book value or sales. Value stocks tend to be less “expensive” or undervalued and generally pay a higher dividend than their counterpart, growth companies.

History has shown that value companies have outperformed growth stocks over time.


For example, in the chart below, notice that value companies beat growth companies 81% of the time over 10-year periods from 1926 to December 2020.


The Best Investments for Income in Retirement - Value Companies Outperform Growth Companies

Past performance is no guarantee of future results, but understanding the performance of value over time can provide greater insights into strategy going forward.


Diversification across value stocks is essential because there is some risk that companies may pause their dividend payments if business slumps and cash flow becomes tight.


If you rely on the dividend from a single company, this could put a significant portion of your retirement income in jeopardy.


Additionally, while value stocks have higher expected returns going forward, they also tend to be more volatile.

You can mitigate the risk of having too few holdings by looking for mutual funds or ETFs that target a diversified bucket of value stocks.


Examples of value funds include:


  • DFA U.S. Large Value (DFLVX)

  • DFA U.S. Core Equity 1 (DFQTX)