One of the most important things retirees look for are ways to fund their desired retirement lifestyle while not outliving their money. With life expectancies increasing, that is becoming even more critical. The best approach to saving for retirement involves looking at several strategies. Financial advisors can provide invaluable guidance for their clients looking to generate income and cash flow during retirement. Even more importantly, advisors can develop a detailed plan to help them make that income last for as long as they might need it.
Take Stock of Current Income Sources
The first step before deciding how to best invest to achieve these goals is to look at current sources of income in retirement. For a typical client, these might include Social Security payments or a pension from a past employer. Perhaps the client has a commercial annuity that will generate a monthly payment as well. Financial advisors also need to take inventory of all of the retirement resources that a client may have at their disposal including:
- Defined contribution retirement plans such as a 401(k), 403(b), 457 and others including the government’s thrift savings plan.
- Interests in a business.
- IRA accounts including both traditional and Roth accounts.
- Self-employed retirement plans such as a SEP-IRA or a Solo 401(k).
- Reverse mortgages.
- Taxable investment accounts.
There may be other assets to consider, but these are among the most common. (For more, see: Tips for Transitioning Your Client from Earning to Drawdown.)
Determine Income Needs
After reviewing the client’s sources of retirement income, advisors should determine how much, if anything, is needed from the client’s portfolio to supplement their existing sources of retirement income. For example, if the client needs a total of $100,000 annually to support their retirement lifestyle and they are receiving $50,000 from Social Security and a company pension, then they need to generate $50,000 in cash flow from their portfolio or other sources. It is important to keep in mind the impact of taxes, so it has to be determined if the $100,000 is gross (before taxes) or net of taxes. (For more, see: How Advisors Can Manage Evolving Retirement.)
Sources of retirement income outside of cash flow from a portfolio might include clients working into retirement either on a full or part-time basis. Many employers are establishing formalized phased retirement programs that offer older employees a reduced role as a bridge to retirement while retaining their knowledge for the organization.
Investing for Income
It’s been a rough few years for income-oriented investors. With the recent rate hikes from the Federal Reserve and the potential for others to follow, this will likely change to some extent. Interest rates on savings vehicles like money market accounts and CDs will likely rise. In terms of generating income there are a number of choices investors can make.
Most of these products are ultra-safe in terms of the risk of loss of any principal. The flip side, however, is the interest earned is paltry at best. This could change as interest rates increase but these accounts should be used for safe returns. By no means should they be used to generate any meaningful income.
The national average interest rate for a money market account in 2016 was 0.26%. As of July 2017, that average has dropped to 0.12% for deposits exceeding $100,000 according to the FDIC.
The rates on CDs are also low, but not as low as money market accounts. CDs require that you lock up your money for a pre-designated period of time. According to the FDIC, the current national average rate on a one-year CD is 0.44% and 0.84% on a five-year CD, again for deposits over $100,000.
These are low returns in exchange for locking your money up, especially for five years. By searching online, you may be able to find better rates. There are also brokered CDs, including jumbo CDs, offered by brokers and financial institutions. Most of these have a secondary market, which provides liquidity. Rates on these types of CDs may be higher than conventional CDs.
Rates for CDs should begin to increase as rates on other money market type instruments begin to rise as a result of the Fed’s rate hikes. (For more, see: How Retirees Should Approach Interest Rate Hikes.)
Bonds come in many varieties and vary by credit quality, type and time to maturity. Coupon interest rates are impacted by the credit quality of the issuer and the time until the bond matures. These bonds typically have a secondary market and the price that they can be sold for can be higher or lower than what you paid for the bond initially.
Most individual bonds pay a coupon rate of interest semi-annually. Investors can set up their individual bond holdings to have incoming payments at various times over the course of the year.
Holders of individual bonds, which are held to maturity, will not be impacted by higher interest rates in the same way as investors in bond mutual funds or exchange-traded funds (ETFs). This is because the coupon rate does not change once the bond is issued and full value of the bond is repaid upon maturity. (For more, see: How Rising Rates Impact Bond Mutual Funds.)
These investment options offer a level of diversification that is difficult for many individual investors to achieve with a portfolio of individual bonds. This access to diversification is especially critical when investing in high-yield bonds or municipals which both carry forms default of risk on individual holdings.
The underlying portfolios of bond mutual funds and ETFs will likely lose value as rates increase. Just how bad these losses might be will depend upon the aggregate duration of the fund, market forces and the steepness of the yield curve. However, with these investment vehicles there is always the strong possibility of long-term gains.
These are a good source of income, as you receive compensation for your investment as long as it is maintained, and in many cases the yields are quite attractive. The downside is that they are still subject to the same inherent risks that come with any other stock investments.
These funds often pay out substantial distributions, but there are a couple things to remember with closed-end investments. In some cases, the distributions can actually be a return of the investor’s principal and can result in a destruction of value. Second, some closed-end funds rely on leverage which can magnify both gains and losses on the funds. (For more, see: Closed-End Funds: A Primer.)
Rather than just investing for income in the traditional sense, retirees need to think in terms of the total income of their portfolio. This means capital gains appreciation as well as the actual yield. Over time, an approach that leaves some cash on the side to fund their cash flow needs, combined with actual income-producing investments and others held for growth is often best for retirees. As interest rates rise, traditional income producing vehicles could become a bigger part of their allocation. This is something that financial advisors can help decide.
The Bottom Line
Current conditions do not present an easy landscape for retirees seeking income from their investments to sustain their lifestyle throughout their retirement. Retired clients need financial advisors to determine the best ways to generate income and achieve this goal. These investment vehicles are worth discussing with clients as life expectancies, and therefore the length of retirement, continue to increase. (For more, see: Advisors: Have Clients Try on Retirement for Size.)