Saving for retirement requires a delicate balance of risk and reward. Too little risk and a retiree may end up with an insufficient nest egg. Too much risk and the egg could disappear entirely. Individuals who are planning on investments for growth, and to provide income during the retirement years, have a variety of options to choose from when building a diversified portfolio. (To help your retirement portfolio grow, check out How To Save More For Your Retirement.)
TUTORIAL: Retirement Basics
An annuity is a contract between an investor and an insurance company. The insurance company pays the annuitant (the holder of the annuity) a fixed or variable amount of money, depending on the type of annuity, on a periodic basis for a specified period of time. Annuities are intended to provide a stable, long-term income stream during retirement.
Fixed annuities offer low-risk retirement income. Annuitants receive a fixed amount of money each month as long as they are alive. Variable annuities generally provide a minimum income - called a guaranteed income benefit option - and an additional payment that varies with the performance of the annuity's investment, allowing annuitants to take advantage of potential growth.
Bond funds are types of investment companies that invest primarily in bonds and other types of debt securities. Depending on investment objectives, the fund can include municipal, corporate, government and convertible bonds, and debt securities such as mortgage-backed securities (MBS).
A bond fund that is fully invested in Treasuries would incur little risk, while a fund that is invested in mortgage-backed securities or junk bonds would be considered higher risk. While bond funds do incur variable levels of risk, they can be used to provide portfolio diversification and a stable source of income during retirement.
Dividend income receives favorable tax treatment, and the continuation of the 15% dividend tax rate (if the individual has a regular income tax rate of 25% or higher) makes dividend-paying stocks appealing. Even when stock prices fluctuate, dividends can provide a steady income stream during retirement. Companies are careful with the size of the dividend they pay. They want to be able to continue paying the same dividend or larger to avoid the bad publicity that comes with cutting dividends. Holding stock in a few well-picked companies can provide a regular paycheck during retirement.
Emerging markets like Thailand, Brazil, Turkey and Israel can provide opportunities for sound investments with the potential for upside growth. In addition, investors can find dividend-paying stocks within the up-and-coming emerging markets.
Criticized for being risky, many of these markets are emerging because they are doing the right things to grow their economies. Many of these emerging economies are climbing the ratings ladder. Brazil, for example, was recently lifted by Moody's to an investment grade status of Baa2 - due in part to the nation's solid banking system. (To help outline the risk involved in emerging markets, read The Risks Of Investing In Emerging Markets.)
Retirement Income Funds
Retirement Income Funds (RIF) are actively managed funds that automatically allocate an investor's money across a diversified portfolio of large- and mid-cap stocks and bond funds. These funds generally apply a conservative methodology to manage the portfolio in a manner that allows for moderate growth and to provide income to its investors. Rather than a guaranteed payout as seen with an annuity, RIFs pay regular monthly or quarterly distributions based on the fund's performance. RIFs are managed to achieve targeted annual income returns, often in the range of 3-12%, though income is not guaranteed.
Cash that is kept in a bank savings account can offer protection since the money is not at risk of losing value, and opportunity because the cash can be withdrawn at any time to use for other investments or emergencies. Some banks offer nominal interest rates on bank savings accounts.
Certificates of Deposit (CDs)
CDs provide a low risk/low reward option for squirreling away money. CDs have pre-determined maturity dates that range from a couple of months to five or more years. Typically, the greater the length of the maturity date, the higher the interest rate. Withdrawals can be made before the maturity date, but will usually incur a penalty fee.
Money markets incur more risk than cash or certificates of deposit, but are still considered safe investments. Accounts may earn slightly more than standard bank savings accounts, and a certain number of withdrawals can usually be made each month without incurring a fee.
Money market funds involve short-term instruments that mature in less than 13 months. The U.S. Securities and Exchange Commission (SEC) mandates that the weighted average maturity of a fund's portfolio be less than 60 days. This restriction helps limit the exposure of a fund to certain risks including sudden movements in interest rates.
Government Issued Securities
Government issued securities include Series EE/E or I savings bonds, treasury bonds, notes and bills. These investments are considered very safe and can be made directly with the U.S. government or a bank. Some of these securities pay no interest until the maturity date, while others pay interest every six months.
The Bottom Line
The recession has forced many pre-retirees and retirees to switch gears, either by working longer than expected, going back to work or even starting over with retirement savings. A balanced and diversified portfolio can offer the opportunity for growth while providing income during the retirement years.
Investors can sustain the greatest risks when they are younger and have decades of work in front of them. As retirement approaches, investors typically use a more conservative approach, focusing more on income rather than growth. (To help you build or construct a stronger retirement plan, see 5 Steps To A Retirement Plan.)