On average, individuals who reach the age of 65 in the U.S. have a life expectancy of approximately 85 years. However, it is important to note that this figure represents the mean and not the definitive lifespan for everyone.
Approximately 33% of individuals who are currently 65 years old are expected to surpass the age of 90, while around 14% are projected to surpass 95 years of age. If you intend to retire in your 60s, which is a common practice, you will need to ensure that your retirement savings can sustain you for nearly three decades. This places a significant burden on a conventional retirement account.
Social Security retirement benefits, particularly crucial for individuals with lower wages, will only cover approximately 40% of your pre-retirement earnings. For instance, if you earned $100,000 annually, Social Security will only replace around 33% of your pre-retirement earnings. To ensure sufficient income during retirement, it is essential to complement these benefits with a pension (if accessible), personal savings, or investments.
Retirees often desire part-time jobs for various reasons, such as maintaining financial stability, staying mentally engaged, and being involved in their communities. However, it is crucial to develop a strategy to generate extra income during retirement and ensure that future earnings can adequately cover increasing living expenses.
Rob Haworth, senior investment strategy director at U.S. Bank, highlights that individuals are becoming aware of the possibility to decrease volatility in their portfolio while simultaneously earning a more competitive income in the current interest rate climate. Given the substantial increase in interest rates, investors who are constructing a retirement income strategy should reassess their choices.
Here are four investment options commonly used to generate income during retirement, arranged in ascending order of risk level.
1. Income annuities
An income annuity is an agreement between you and an insurance company. In this arrangement, you can either make a lump sum payment or opt for monthly payments. In return, you receive a steady stream of income at regular intervals. Annuities provide the opportunity to establish a guaranteed source of income for a specific duration or your entire lifetime. Additionally, you have the flexibility to select whether the payments are based solely on your lifespan or on the combined lifespans of you and another person, such as your spouse.
When you purchase an annuity, you provide an agreed-upon sum to an insurance company, knowing that the funds will be disbursed to you either immediately or in the future, depending on the annuity type. During the time your money is held by the insurance company, it can potentially grow without being taxed. Once you decide to receive payments, you have the option to receive a fixed amount regularly or adjust it for inflation. To find the most suitable annuity for your requirements, a financial expert can assist you.
Annuities can offer security, potential long-term growth, and a source of income for a part of your retirement savings. Many retirees opt for annuities to enhance their guaranteed income from sources like Social Security, effectively covering unavoidable expenses. Due to their income guarantees, annuities are commonly regarded as a form of protection against the possibility of exhausting your retirement funds prematurely.
Annuities can provide:
In retirement, you can enjoy a reliable and consistent income that remains unaffected by market ups and downs. Experience tax-deferred growth and benefit from tax advantages on your income. Take advantage of flexibility in saving and receiving money throughout your retirement journey. Additionally, there is the potential for your beneficiaries to continue receiving payments even after you pass away.
Challenges of annuities:
The claims paying abilities of the underlying insurance company determine the validity of guarantees.
There could be limited liquidity available.
A 10% tax penalty could be imposed on annuity withdrawals made before reaching the age of 59 ½.
If your annuity is not backed by a top-rated insurance company, the potential risks may increase.
2. A diversified bond portfolio
In the past, bonds were not seen as a strong income option for retirees. However, with the Federal Reserve increasing short-term interest rates, bond yields have also risen. For instance, the 5-year U.S. Treasury note had a yield of 1.37% in early 2022, but by May 2023, it had increased to 3.74%.2
There are various options when it comes to bonds. You have the choice to invest in specific bonds such as U.S. Treasury securities, municipal bonds, corporate debt instruments, government entity bonds, mortgage-backed securities, and international bonds. The yield of these bonds will depend on factors like the credit quality of the issuer, the bond’s maturity period, and the current market situation. To simplify the process, many investors opt for bond mutual funds, which offer a diverse portfolio of bonds managed by professionals.
When you invest in a bond, you will receive regular income payments from the issuer according to the stated annual yield. You have the option to keep the bond until it matures, at which point the principal will be paid back by the issuer. Alternatively, you can decide to sell the bonds on the open market before they reach maturity.
Bonds can have varying market values compared to their face value, depending on the interest rate environment and remaining term. When current market rates are higher than a bond’s yield, it will be priced at a discount to entice buyers. Conversely, if current rates are lower than the bond’s yield, it will sell at a premium. This highlights an often disregarded aspect for bond investors – despite being seen as lower-risk investments, bonds can still experience value fluctuations.
Bonds can provide:
Consistent flow of earnings with the potential for competitive returns.
Flexibility in portfolio mix is enabled by liquidity, allowing for timely adjustments.
There is availability to a diverse selection of fixed income instruments offering various yields and risk profiles.
The capacity to offer efficient diversification as a means to balance risk in a portfolio comprising equities and various other asset classes.
Challenges of bonds:
Income paid to you is subject to tax at ordinary income tax rates, with the exception of tax-free municipal bonds.
If interest rates increase and the investor is required to sell the bond, there is a potential risk of losing the principal amount.
Challenges may arise in generating comparable income in the future while replacing maturing bonds.
Income streams in a bond portfolio do not provide inflation protection.
3. Total return investment approach
By employing a total return strategy, your investment portfolio generates income through interest, dividends, and capital gains. Such a portfolio is designed to invest in a well-rounded and varied combination of stock and bond funds.
In this particular situation, when we refer to “total” return, it implies utilizing a portion of the average annual rate of returns, which includes both income and appreciation, over a longer timeframe (10-20 years). Instead of solely concentrating on specific annual return rates or solely relying on the income derived from the portfolio’s holdings, the objective is for this overall return to meet or surpass your withdrawal rate.
Haworth suggests that this method enables individuals to expand their retirement portfolio in order to ensure it remains aligned with the requirements of those preparing for a retirement period that may extend for 20 to 30 years or even more. Additionally, this approach may provide an opportunity to generate a higher overall return in comparison to the conventional investment strategies typically adopted during retirement.
In relation to withdrawal rate, the total return approach adopts a “systematic withdrawal” strategy, where an annual distribution is made, consisting of a specific percentage of your investment. Typically, the distribution amount falls within the range of 3 to 5% of the overall portfolio value.
A total return approach can provide:
One way to address your immediate cash flow requirements while simultaneously growing your savings for future expenses, which are expected to increase due to inflation, is by following this approach.
The capacity to employ a wider variety of resources compared to conventional methods for generating retirement income.
Portfolio withdrawals, predominantly derived from capital appreciation, offer the potential for a more tax-efficient source of income.
Challenges of a total return approach:
It cannot be assured that funds will endure throughout retirement.
There is no fixed withdrawal rate, resulting in potential fluctuations in the value of your return each year.
Retirement may face the risk of depleting assets before its completion, especially if investments experience substantial decreases during the initial years.
4. Income-producing equities
Although the main purpose of investing in stocks is to achieve capital appreciation in a portfolio, there are certain equities that offer income through dividends. Companies that are publicly traded often distribute a portion of their profits to shareholders in the form of dividends. It’s important to note that not all stocks provide dividends, and among those that do, some tend to offer higher dividend payouts than others.
According to Haworth, the appeal of stock dividends increased significantly during a period of exceptionally low interest rates in the bond market. Although the dividend yields of most stocks may not currently match up to bond yields, they still present the possibility of earning capital appreciation.
Dividends are usually paid by companies every quarter, but there may be instances where a “special dividend” is issued due to exceptional circumstances. However, these occurrences are rare and should not be relied upon. Unlike most bonds, stock dividends can fluctuate with each payout period, and there is a possibility that companies may stop paying dividends altogether. Therefore, it is important to be aware that dividend payments can be uncertain.
If your main objective is to invest in a stock for generating income, it is crucial to examine its track record of paying dividends. Stocks that have consistently or steadily increased their dividend payouts in the past are likely to be the most appealing options to consider for this intention.
REITs, also known as publicly-traded real estate investment trusts, offer an opportunity to enhance portfolio diversification for investors predominantly holding stocks and bonds. These equity investments are corporate entities engaged in ownership, operation, or financing of real estate properties that generate income.
REITs that are publicly traded are available for purchase and sale on major stock exchanges, making them as easily tradable as stocks. The prices of these REITs vary on a daily basis. According to Haworth, investors need to consider price fluctuations because they are not solely influenced by the underlying value of the REIT’s assets. External factors that affect the overall investment environment can also impact the price you pay for a REIT or the price you receive when selling it.
Income-producing equities can provide:
Consistent dividend payouts are provided by companies that generate strong earnings, resulting in a steady stream of income.
This presents the chance to gain from both the capital appreciation potential and income generated by stocks.
Dividend income serves as a “built-in return” on your equity investment, independent of the stock’s price movement.
Publicly-traded REITs offer a means of diversifying a retirement portfolio’s income sources, particularly when the portfolio is predominantly composed of stocks and bonds.
Challenges of income-producing equities:
The principal value of other traditional income vehicles, like bonds, experiences less fluctuation compared to principal value in general.
Some companies lack reliability and consistency when it comes to their dividend payouts.
As interest rates rise, stock dividends may lose their appeal.
Dividend income is taxed at higher rates, similar to ordinary income tax rates.
Finding the right strategy for you
When planning for retirement, it is important to consider your time horizon and risk tolerance when choosing investment options. Seeking assistance from a financial professional can provide a better understanding of these options and help determine which ones are suitable for your retirement income strategy. By taking the time to comprehend your options and assess your overall financial situation, you will be better prepared to approach your retirement years with confidence.