The best investments for retirement combine tax advantages, return, safety, inflation protection, liquidity, and income.
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by Michael Sharpnack
A diversified portfolio of stocks and bonds can capture the advantages of all the important elements of the best investments for retirement: tax advantages, return, safety, inflation protection, liquidity, and income. It’s liquid; it has return and inflation protection from stocks, safety from bonds, and it efficiently provides for income.
Every situation is unique, though, and some occasions arise where another type of investment should be used.
Unfortunately, other investments are often used when a diversified portfolio would be best.
This post will examine the most common investments used for retirement, weigh the pros and cons, and then explain why we prefer a diversified portfolio.
Here are the three most common categories of investments for retirees:
- Insurance products
- Income-producing investments
- Investment portfolios
Insurance Products as a Retirement Investment
Two types of insurance products are commonly used as savings vehicles for retirees:
- Life insurance.
These two work in opposite ways, yet they are both commonly used as investments in retirement.
Here’s how they work:
Annuities as a Retirement Investment
Annuities are complicated products, and there are many different types, but at their core annuities are a contract between you and an insurance company.
You give the insurance company a sum of money in return for certain guarantees or assurances, depending on the annuity.
Two types of annuities are available: fixed and variable. But there are many variations of each, with different riders and features available.
The most basic annuity—though not very common these days—is a simple life immediate annuity. Also called a SPIA (Single Premium Immediate Annuity) on a single life. With this type of annuity, you pay the insurance company a lump sum of money, and they provide a guaranteed stream of income for life. You lose access to the principal, but the income stream will never run out.
Every other type of annuity will have additional features, but also additional costs and complexity.
There’s always a trade-off with an annuity: you give up something to get a guarantee.
This trade-off is important to remember. Annuities are sometimes sold as if they have no downside. But if something sounds too good to be true, it probably is. Insurance companies need to make a profit, too.
With the basic annuity the insurance company will pay you a set amount of money every month for the rest of your life—whether you live three years or thirty years. The longer you live, the more money you get. That’s the risk the insurance company takes. Conversely, the shorter you live, the less money you get. That’s the risk you take.
The purpose of an annuity is income you can’t outlive.
On its own, this guarantee is a great feature. It gives consistency and predictability of income. It guards against volatility in the market. It also helps relieve the fear of spending all your assets while you’re still alive and having nothing left when you enter old age.
In some situations, this income stream is the right choice. Most of the time, however, the costs outweigh the benefits.
The cons vary depending on the specific type of annuity, but here are some of the problems with annuities:
- Limited or no liquidity
- High commissions and fees
- No inflation protection without additional cost
Loss of liquidity
When you purchase an annuity, the principal is usually tied up with restrictions and surrender charges.
The loss of liquidity is dependent on the type of annuity.
If you annuitize, the liquidity is gone. “Annuitize” means that you start the guaranteed stream of income from the annuity. It’s the classic way to get income from an annuity.
You hand over your money and the insurance company promises to pay you every month for the rest of your life.
If you die next year, the principal is gone. There’s no inheritance leftover. If you have an emergency and need to pull out an extra hundred thousand, you can’t. If you want to go in on that vacation property with your brother because he’s been pestering you about it for years … you get the idea.
The loss of principal can be alleviated with options such as a period certain, where the insurance company will pay back your principal if you die within a certain period, such as ten years. But with each option there is a reduced payout, and there still isn’t full access to the principal.
If you don’t annuitize, the situation is a little more complicated.
You can hang on to an annuity without annuitizing it, and it functions like an investment account but with certain features and restrictions. In this category are deferred annuities and annuities with an income rider.
In either case, you may have access to the principal, but there will usually be surrender penalties. For example, you might have a surrender period of ten years where if you withdraw the money in year one, there is a 10% penalty; if you withdraw in year two, there is a 9% penalty; and the percentage continues to decrease each year until after ten years there is no more penalty.
The other problem with using a deferred annuity or an income rider is that your monthly payment is usually lower than when you annuitize.
With income riders, once you start payments, the payment doesn’t continue to increase, while your account value is still subject to fees and the cost of the rider.
Before purchasing a product, fully understanding how it works as well as the costs and the implications for the future is important.
Everything has a trade-off.
The highest payment requires you to lose complete access to the principal and any inheritance you want to leave. To gain more liquidity, the payments get lower.
Annuities often pay 5-10% of your initial investment to the salesperson.
The commission is why there is a surrender period. The insurance company pays the salesperson upfront, and then makes that money back with fees and interest earned on the account. But if they pay the salesperson 10%, it may take ten years to make the money back. So, they introduce a surrender penalty to make their money if you get out before ten years.
The upfront commission cuts into the growth and income potential of the money.
Insurance companies also charge fees to maintain the account. These are usually called “mortality and expense charges,” and that’s how the insurance company is compensated for the income guarantees they offer. These insurance fees can be in addition to investment management fees.
The ongoing fees also cut into the return each year.
No Inflation Protection Without Additional Costs
Inflation is one of the biggest risks against you in retirement, so you must prepare for it.
But with a standard annuity, there is no inflation protection. You annuitize and the payments stay the same each year. Fifteen years from now, the payments are still the same, but prices have gone up. Long-term healthcare costs have gone up, too. The payments may no longer be sufficient to cover expenses.
But at that point there’s nothing you can do—the principal has been locked in.
There are ways annuities can offer some inflation protection, but they have costs. You can purchase an inflation rider, but that will significantly lower your monthly payment. Variable annuities offer higher returns to protect from inflation, but they are subject to higher costs as well. Fixed indexed annuities may promise annual increases in income, but they have problems such as high costs and phantom accounts.
Because annuities don’t naturally offer inflation protection, it’s expensive to add it on.
Deciding on an Annuity
Because so many kinds of annuities exist, and insurance companies use different language to describe these variations, an investor can have a difficult time deciphering what they are actually purchasing.
You should never buy something you don’t fully understand.
Additionally, annuities are usually less efficient at creating retirement income.
From a high-level view that just makes sense: you’re adding an additional party (an insurance company) to your investments. Insurance companies not only need to be paid, but they are required by law to keep a certain percentage of assets in bonds, limiting their return potential.
Historically, you can take at least 4% of an investment portfolio for income—with built-in inflation protection—maintain access to principal, and have an inheritance left over. It’s hard to find an annuity that can beat that for most people.
Annuities are often marketed to appeal to our fear of scarcity. However, reality is often different from the sales pitch.
Life Insurance as Retirement Income
Life insurance is meant to provide financially in the event of death, but it’s also commonly sold as a way to accumulate assets for retirement.
The strategy for life insurance is to purchase a whole life policy and pay the premiums while you work so the cash value grows tax-free. Then, in retirement, you can borrow from the cash value as a tax-free loan to yourself.
But there are many problems with life insurance as a retirement investment.
The main problem with this strategy is low return.The cash value of a life insurance policy is invested in—you guessed it—cash (short-term bonds and money markets). Cash isn’t a great long-term investment because it often loses money after inflation. You also have the added insurance expenses, further reducing your return.
If you’re approaching retirement and you already have a whole life policy, then the first question is whether or not you need the death benefit. Usually those approaching retirement have enough assets to be self-insured, so there’s no need to maintain the policy. The insurance has served its purpose.
If you don’t need the death benefit anymore, cashing out the policy and investing the proceeds into your diversified portfolio is usually better.
If you don’t have a whole life policy and you’re looking to build wealth for retirement, you should look at other solutions first.
Another common strategy for retirement income is using various income-producing investments.
Income-producing investments are a broad category, but we’re talking about any kind of investment product that produces income. The retirement strategy is to live off the income the investment produces while not taking any money from the principal.
Here are three of the most common types of income-producing investments used for retirement:
- Dividend stocks
- Interest income investments (bonds, CDs, savings accounts, etc.)
A REIT (Real Estate Investment Trust) is a company that invests in various income-producing real estate, and then shares the profits with investors.
They are marketed as a way to get in on real estate income without the hassle of finding and managing properties. REITs package a group of income properties into one unit. They then sell the unit to investors as individual products, promising a portion of the income generated from the rent.
REITs often promise high returns, quarterly dividends, and long-term leases—all backed by stable properties like fast food restaurant franchises, hotels, or hospitals.
There are both traded REITs and non-traded REITs. Non-traded REITs are very risky investments, while publicly traded REITs function more like an ETF that invests in real estate.
Non-traded REITs are commonly sold directly to investors by local brokers and advisors because of the commission.
Here are three problems with using non-traded REITs for retirement income:
- High commissions
- Income isn’t guaranteed
- Illiquid: even if the income stops, you might not be able to get out
- Poor diversification
REITs are commission-based products where the salesperson can make 8-10 percent to get you in. That’s a big chunk that lowers the overall investment potential. It’s also an incentive to sell it to you, even if it’s not in your best interest
Income Isn’t Guaranteed
If the properties in the REIT go out of business or fall on hard times, the REIT makes no income, and you don’t get paid. The rate can drop to zero, or they can suspend the payments.
Tough to Get Out
Once you buy a non-traded REIT, it’s tough to get rid of. There is no open market to trade them, and companies don’t buy them back. If you want out, your only option is to find a third-party speculator, typically buying for pennies on the dollar.
Since a REIT is invested only in real estate, you only have access to once asset category. If the real estate market tanks, the REIT can go to zero. There’s nothing else to provide diversification.
Dividend stocks are another income-producing investment used for retirement income.
Dividend stocks pay a specified dollar amount per share to those who own the stock. This amount is called a dividend, and they usually pay out quarterly.
The strategy is to fill a retirement portfolio with dividend stocks and live off the dividends as income. You can live off the dividend income without selling any stocks or dipping into the principal. And, because you’re invested in stocks, there’s opportunity for the principal to grow.
But there are problems with dividend stocks. Here are three:
- Higher risk
- Dividends could stop
- Lack of diversification
Dividend stocks pay a high dividend relative to their price, which means investors don’t think highly of the company.
To understand the problem, let’s look at where dividends come from. First, a company has earnings. Earnings are sales minus expenses. So, they sell things and make an income, and then they have expenses like the cost of goods sold, taxes, and interest. Subtract the expenses from the sales and you have earnings.
A company can split those earnings two different ways: One, they can retain earnings—put them back into the company to help it grow for the future. Or two, they can pay a dividend to stockholders.
Let’s compare two companies. One sells for $100 and pays a $3 dividend, and the other sells for $50 and pays a $3 dividend. Which one do you want to buy in a dividend stock portfolio? Well, you can get twice the dividends for the same amount of money in the $50 company. Investing $1,000 gives you $60 in dividends, versus only $30 in the $100 company.
But if both companies pay the same dividend, why is the price for one so much lower?
Companies have lower prices because investors think less of the company. Maybe it has weak financials, low profits, or bad management. If two companies pay the same dividend, but one is priced less, that means investors think the lower priced company is struggling. Struggling companies are high risk companies.
It doesn’t make sense for an older investor—dependent on the dividends for income—to fill their portfolio with risky companies.
The Dividends Could Stop
A company paying high dividends today might not pay high dividends in the future.
Difficult economic times can force a company to stop paying their dividends. Competitive pressures from other companies can cause a company to retain more earnings in order to keep up, thus cutting their dividends. The government could also increase the tax rate on corporate dividends, making companies cut their payments.
This problem is compounded in dividend income portfolios because they seek companies that pay a high dividend relative to their price.
Lack of Diversification
Investing in single stocks—like dividend stocks—is much less diversified than mutual funds.
But even dividend stock mutual funds are not well diversified because dividend stocks tend to be the same types of companies. That means they will be affected by similar market conditions.
Instead, a diversified retirement portfolio should have many different types of companies. The right types of companies won’t all be affected by the same market conditions; therefore, they help reduce risk.
Interest Income for Retirement
Another common strategy for retirement income is to use interest-paying investments like bonds, CDs, or money markets, and then live off of the interest in retirement.
Now, in today’s (2021) interest rate environment, this is less common. But we used to see this strategy much more when interest rates were higher. Still, interest-paying investments are appealing for retirement because you can live off the interest without spending the initial investment. And because you’re invested in bonds, the principal is not subject to the market volatility of stocks.
For example, put $500,000 into a 2% interest account. That interest generates $10,000 per year of income. Live off the $10,000 per year, and you never draw down the $500,000, ensuring a sustained income and an inheritance for your heirs.
The problem is another less-obvious risk is involved—inflation risk.
The strategy works great if $10,000 holds the same value each year, but in reality, $10,000 declines in value each year because inflation erodes the purchasing power quickly.
Retirement lasts a long time. There’s about a 50% chance that a married couple will need their retirement assets for thirty or more years. Think about the income you made thirty years ago. Could you live off that today?
The average income in 1990 was $20,000, while it’s $56,000 today. That’s a difference of 2.8 times. Apply that same difference today—and inflation has been lower recently than the historic average—and that means you would need $156,000 in thirty years to live the same lifestyle that you live today.
It’s hard to imagine needing that much, but back in 1990 it was hard to imagine the average person needing $56,000, too.
Also, $500,000 won’t be the same inheritance in thirty years as it is today. That would be like retiring with $178,000 in 1990 and leaving that to your heirs today.
Thus, interest-paying investments don’t protect from inflation.
Compare how stocks recover from a downturn versus bonds. The market bottom during the Great Depression was 1932. A 60/40 portfolio completely recovered by 1935. But if you cashed out in 1932, it would take about 500 years to recover based on the treasury bill yield at that time.
The other problem with a portfolio made entirely of bonds or CDs is that it’s inefficient for income. It takes more assets to get the same income from bonds than it does with other strategies.
With an investment portfolio, for example, studies show you can take 4% for income and increase it each year. If interest rates are at 2% (which is generous right now) then you need double the assets to get the same income—and still without annual increases.
Bonds and cash have their purpose, but they don’t work well as the sole investment in a retirement income portfolio.
The Best Investment for Retirement: Diversified Portfolio
A diversified portfolio of stocks and bonds has the best combination of safety, return, inflation protection, and liquidity for retirement income.
There are many different ways to set up investment portfolios, but it’s essential the portfolio is diversified according to academic research. Having a mix of stocks and bonds is not enough. There must be different types of stocks—such as US, international, small, large, growth, and value stocks—and the right types of bonds.
The general idea is to set up the proper mix of stocks and bonds, and then draw a percent of income from the total portfolio each year. The ideal mix is between 50%-75% stocks, and the research shows you can take at least 4% annually from that mix.
Bonds provide the safety in the portfolio, and stocks provide the return and inflation protection.
High-quality bonds tend to hold value during even the worst downturns, and can often go up in value during downturns. If your portfolio is 40% bonds and you’re withdrawing 4% of income, that means you have 10-years worth of income in bonds. If stocks are in a downturn, you can take income from bonds while the stocks recover.
Stocks can protect against inflation because when prices go up due to inflation, companies (stocks) are the ones raising prices. Large US stocks have historically provided a 10% annualized return, while other areas of the market have even higher long-term returns.
Finally, with standard investment accounts, you can withdraw any amount of money at any time, and with no penalties as long as you’re over 59 ½ for IRAs and certain other qualified accounts.
Investment accounts don’t lock up your principal, they don’t have surrender charges, and they give you the opportunity to leave an inheritance to the next generation.
Keep in mind, however, that every situation is unique.
The best investment often depends on your expenses in retirement.
You should always seek the advice of an experienced financial planner before making a retirement income decision.
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.