As you move toward retirement, the investments you’ve relied on to build a retirement savings portfolio may not be the best fit when it comes to generating retirement income.
If you’re like most near-retirees, you’ve worked hard to save through your company 401(k) plan, IRAs or Roth IRA accounts. Most company-sponsored retirement plans offer a mix of mutual funds made up of stocks and bonds. Some of the more growth-oriented funds likely have more stocks, while the more income-oriented funds likely have more bonds. Those options were solid while you were in the accumulation phase.
For many years, the conventional wisdom in retirement planning focused on a simple balanced stock-and-bond portfolio that slowly evolved over time toward more bonds and fewer stocks. The rationale behind such a recommendation was that this kind of portfolio created less volatility, the potential for growth and offered more income as retirees aged.
Today, this conventional wisdom may not work well for many retirees. That’s because extremely low bond yields generate very little income while increasing portfolio volatility. If you buy bonds or bond funds at current low rates, those bonds will lose value if interest rates rise in the future.
When you can’t depend on bonds or bond funds to generate a decent amount of income and lower the risks in your portfolio, it doesn’t make sense to rely on them as a major building block of a retirement income portfolio.
If you can’t rely on bonds or bond funds, you need to fill that gap in other ways. That’s where alternative assets come into play. Potential alternatives that we’ll explore include real estate, options and fixed index annuities.
An alternative investment is a financial asset that does not fall into one of the traditional investment categories. Traditional categories include:
Alternative investments typically have a low correlation with those of standard asset classes. This low correlation means they often can generate returns regardless of market direction. This feature makes them a suitable tool for diversification.
Alternatives possess many other advantages, including hedging against inflation, which is the tendency for prices to increase over time. Alternatives may lower portfolio volatility and in today’s interest rate environment, potentially increase portfolio returns.
Alternative assets can also add needed income to retirement income portfolios while decreasing risk.
Of course, alternatives have their downsides. They can be less liquid than traditional investments, such as stocks and bonds, which means it can be difficult to turn those investments into cash should you experience a financial emergency. They aren’t immune from downturns either – no investment is. They may be more expensive than stocks and bonds, depending on which alternatives you choose and where you get them.
With that said, here are three strategies that can diversify your retirement income portfolio.
As an asset class, real estate has the potential to benefit retirement income portfolios when employed appropriately. You can invest in real estate locally by buying houses or apartments to rent out on a long or short-term basis. You can also invest in real estate through both publicly traded or non publicly traded real estate investment trusts (REITs) in any area of the United States or the world.
There are also a variety of property types to choose from, including office buildings, shopping centers, residential and industrial. Whether you invest in real estate locally or through publicly registered vehicle such as REITs or funds that own REITs, real estate can provide a steady stream of income and significant tax breaks.
Before investing in real estate, it’s wise to consider the disadvantages. If you buy individual properties, real estate can be illiquid and leveraged. That means it can be hard to sell to convert into cash and that you may have to borrow money to buy the properties you are interested in. If you buy REITs or REIT funds, those can suffer from downturns in the real estate market, cutting down on the income you receive and depressing the value of the shares.
The easiest way to invest in real estate is through publicly traded REITs that trade on the stock market. The main disadvantage of these types of REITs is volatility. While the purpose of an alternative asset is to add diversification, it is wise to look for one that reduces volatility as well. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you are trying to achieve.
Instead, consider looking into non publicly traded REITS. They often have a much lower correlation to the stock market as they are not traded like stocks. They get most of their value from the underlying real estate itself and not stock market share prices. This in turn reduces volatility and increases consistent returns.
Options are a type of derivative financial instrument with a value based on an underlying asset, such as stocks. There are many ways to use options. Within a retirement income portfolio, options offer the potential to increase income while reducing risk.
One option strategy that can be productive is that of taking advantage of the natural time decay of short-term options. You see, when trading options you can be a buyer, often thought of as speculative investment, or a seller, often thought of as the premium collector.
One premium collection strategy is known as the credit spread strategy. This strategy can be complex and does carry risk, but can also provide regular income if traded successfully. By collecting options premium when selling you may be able to benefit as the value of options decline, which time decay measures. The goal is to collect premium and not have to give it back and for the option to expire worthless. If that happens you get to keep all the premium you received. If not, losses could occur. This strategy can create supplemental income without exposure to rising interest rates. Furthermore, you can target though probabilities, a probability of success that you feel most comfortable with. This type of flexibility is hard to find in other investments.
Options are highly liquid, which is a desirable attribute for a retirement income portfolio. Options also have their disadvantages, which include the potential to lose principal and taxation as short-term capital gains.
Fixed indexed annuities (FIA), which are issued by an insurance company, are a contract between investors and insurance companies. As an alternative to bonds or bond funds, FIAs provide tax-deferred growth, protection from downside market risk and a regular stream of income.
Because FIAs are an insurance company product, they can offer the potential to capture some stock market gains while avoiding stock market losses. They can also offer guaranteed income in retirement. Unlike bonds or bond funds, partial distributions known as free withdrawals are common contractual guarantees in fixed indexed annuities that permit access to a portion of the account value each year that could be used to pay for ordinary household bills. This replaces the need to potentially liquidate bonds at a discount in a rising interest rate environment, reducing interest rate risk.
FIAs can be complex products that may offer additional options — known as riders — that can provide lifetime income for you or surviving spouses and ongoing income in case of age-related incapacity, among other benefits. These riders come at an additional cost to the underlying cost of the annuity.
Annuities can be expensive if not structured properly. They also have limited liquidity, meaning that your money is committed to the company for a certain period and not available to spend in other ways. Before purchasing an FIA, make sure that you fully understand the provisions, the time commitment and all the fees involved.
Alternative assets offer the potential to reduce volatility, enhance cashflow, improve diversification and boost returns, depending on how they are employed in a retirement income portfolio. Using any one or all of these techniques may help you achieve more diversification, reduce risk and create more income in retirement.
Co-Founder, Tru Financial Strategies
Nathan Chapel is the co-owner and co-founder of Tru Financial Strategies. Since his start in the insurance and financial industry in 2009, he has had the opportunity to serve hundreds of people with their retirement needs with the mantra, "Protect your wealth, provide for your future." Nathan holds the Series 65 securities license and serves as a fiduciary adviser.
Co-Founder, Tru Financial Strategies
Scott Svoboda is the co-owner and co-founder of Tru Financial Strategies. Since his start in the insurance and financial industry in 2012, he has had the opportunity to serve hundreds of people with their retirement needs with his mantra, "Protect your wealth, provide for your future." Scott holds the Series 65 securities license and serves as a fiduciary adviser.