Retirement Income Options
There are many options for growing a retirement nestegg. Don't fall into the trap of assuming that one of these investment options holds to key to a secure retirement. In fact, your portfolio should leverage a mix instruments to protect against volatility. The following investment options are popular for retirement planning:
IRAs and 401(k)s
IRAs were first offered in 1974. Since then, they've become one of the best ways to save for retirement. Traditional IRAs are tax-deductible and grow tax-deferred. The assumption is that the retiree will be in a lower tax bracket after retirement and will therefore benefit by deferring taxes until a later point in time. Roth IRAs are not tax-deductible but they do grow tax-deferred. Unlike traditional IRAs, the distributions are paid tax-free.
401(k)s are employer-sponsored defined contribution plans. They are funded with pre-tax dollars that allow employees to deduct the amount they contribute from their annual income. Contributions are very easy to make, as they are usually made through payroll deductions.
Most employers that offer 401(k) plans (or the public sector equivalent 403(b) or 457 plans) provide a matching contribution. For example, an employer might match 100% of an employee's salary up to 6%. Financial planners and tax professionals do everything they can to make sure their clients participate in employer-sponsored retirement plans. Employees who don't contribute at least the amount required to receive the employer's maximum match are passing up free money.
Pensions are employer-sponsored defined-benefit plans. They were previously one of the only ways Americans had of receiving income once they retired. Over the past several decades, pensions have largely been replaced with 401(k) plans and other types of defined-contribution plans that place the burden saving for retirement mainly on the employee.
Even if the company you work for offers a pension, it's still a smart idea to save on your own for retirement. While pensions have some protections under federal law, a company can reduce the amount it pays, or stop payments altogether at any point. This is especially true during economic downturns. Companies sell fewer products and services and therefore have fewer revenues and profits to pay past employees.
Annuities are a much different type of investment. They are contracts between an insurance company and an investor. In exchange for purchasing the contract from the insurance company, the investor receives payouts under the terms. The investor can earn and be paid a fixed or variable amount. Unlike stocks, bonds, mutual funds, or ETFS, an annuity can't just be sold. Once the contract is in force, it cannot be changed.
Annuities, however, provide a different level of retirement income options. For example, a lifetime income annuity pays the owner a fixed amount each month for as long as he or she lives. Even if the annuitant lives well past the life expectancy that the insurance company used to calculate the payments, and even if the payouts exceed the premium, the insurance company is obligated to make payments until the annuitant dies. For healthy individuals who expect to live well past the current life expectancy for their age, gender and state of health, annuities can offer peace of mind.
The downside of annuities is that the investor cannot cancel the contract. The money that is used to purchase the annuity will not be returned except in the form of the payouts. Only those who have additional liquid assets should consider annuities.
Stocks are typically divided into two categories: growth and value. Growth stock companies show a strong earnings growth, return on equity, and earnings per share. Value stock companies are still strong companies, but the price of the stock is undervalued based on earnings and book value. Both growth and value stocks can pay dividends, which can provide a large part of retirement income for people with a sizeable portfolio.
Growth stocks and equity funds are also needed to offset the effects of inflation. While many people don't want to own stocks after they've retired because of the volatility, they need at least a portion of their assets to continue growing. Retired investors who aren't comfortable with the risks should at least own equity mutual funds. Mutual funds offer instant diversification. They also ensure that if the value of one or two stocks decline, the value of the stocks that don't decline will help to support the price of the fund. Diversification can be easily achieved by owning funds that specialize in different market sectors and even in different countries.
Exchange Traded Funds and Mutual Funds
Exchange traded funds (ETFs) share properties of both mutual funds and stocks. Like mutual funds, an ETF consists of several stocks that are grouped together and traded as one unit. The value of a mutual fund or ETF is determined by the rising – or falling – value of the stocks within the unit. Like stocks, ETFs can be traded at any time of the day. The value of the ETF fluctuates during the day as the prices of the stocks within it fluctuate. The price of a mutual fund, however, is determined at the end of the day, once the value of all of the stocks within it are known. In other words, a mutual fund has only two prices during the day: The price at which it opens and the price at which it closes.
ETFs provide investors with a way to diversify assets, trade quickly, and incur lower lower fees.. Popular ETFs trade the S&P 500, Dow, and NASDAQ exchanges.
When governments or corporations issue bonds, they are in effect selling debt. They are borrowing money from the purchasers of the bonds to meet current financial obligations or to finance future projects. In exchange for being loaned the money, they agree to pay a rate of return for a specified amount of time.
Bonds issued by the United States government are known as US Treasuries. They are sold as bills, which have maturity dates of one year or less; notes, which have maturity dates between one and 10 years; and bonds, which mature between 10 and 30 years.
Corporate, US Treasury, state, and municipal bonds can be purchased individually or as part of a bond fund. Corporate bonds almost always pay a higher yield than US Treasuries because they present a greater risk of default.
Certificates of Deposit
Certificates of deposit (CDs) are not usually a good retirement income option. However, they are very low-risk investments and a good way to protect assets until better investment opportunities present themselves. The Federal Deposit Insurance Corporation (FDIC) insures CDs up to $250,000 per account owner. (A CD owned jointly by a couple is insured up to $500,000.)
CDs with longer terms will usually pay a higher rate. CDs are "time instruments". The CD is purchased for a fixed dollar amount for a fixed length of time, the most common of which are six months, and one and five years. Interest is paid at regular intervals and when the CD is redeemed, the owner is paid the original purchase price along with the interest that has accrued.
A traditional CD usually pays the least amount of interest. A "bump up" CD pays higher returns if interest rates are rising. "Liquid" CDs provide the owner the opportunity to take out a portion of the money in the CD without having to pay a penalty. A "zero-coupon" CD works like a zero-coupon bond: CDs that are "callable" are sold at one rate, then "called away" by the bank and returned at a different rate. The "high-yield" CD pays a much higher rate than all other types of CDs, but usually with a greater risk of default.
Money Market Accounts
Like CDs, money market accounts are a great place to put extra cash, but not a viable retirement income option. Money market funds are required by law to invest in low-risk securities. The interest paid on this type of account is directly related to short-term interest rates. The manager of the fund attempts to keep the value at a consistent $1.00 per share.
Real Estate Investment Trusts
Real Estate Investment Trusts (REITs) invest in real estate. The investment can be direct ownership of property or through mortgages. REITs typically offer high yields at higher than average risk. There are two types of REITs: Equity REITs that invest in the property of the company that sells the REIT, and mortgage REITs that loan money to the owners of real estate or purchase mortgage backed securities.
REITs trade like stocks. Owning REITs is a further way to diversify your retirement portfolio.
While we've covered the basics of retirement planning here, there is much more to securing a great retirement. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Retirement Planning Guidance
- Retirement Planning Guide — The complete guide to retirement planning.
- Retirement Savings Tips — Tips for how to saving for retirement.
- Building a Solid Retirement — A practial guide to implementing your retirement plan.
- Early Retirement — What it takes to plan an early retirement.
- Inflation — Understanding how inflation affects retirement planning.
- Assest Allocation & Diversification — Learn how to manage investment risk.
- Retirement Pitfalls — Common retirement planning mistakes you'll want to avoid.
- Tax Considerations — How to minimize tax burden while saving for retirement.
- Retirement Planning FAQ — Frequently asked questions about retirement planning.