Retirement Income Planning Made Simple

by Neal Frankle, CFP ®

Retirement income planning isn’t so easy these days with a rocky stock market and ridiculously low interest rates. Here are a few good choices and the pros and cons of each:

1. CDs

Not my favorite choice with rates this low. Who wants to lock up their money for three years and earn next to nothing for it? Forget it.

Even when rates climb, that’s only because inflation is rising. Bank interest rates usually are just above inflation. If you take that inflation factor out (plus taxes) you will always come out on the short side of the stick. CDs are not a retirement income investment.

But CDs might work if you have so much money you don’t care about the return. The other time it might be a good idea is if you need liquidity because of health or other concerns. Either way, CDs are not a good choice for retirement income investments even though they may, under certain circumstances, be a good choice for your retirement investments. In other words, when income isn’t your goal, CDs might be a good choice.

2. Bonds

Bonds might be a solution for you, but be very careful, especially now. Bonds are basically a loan. You loan money to a government or a corporation. They promise to repay you. That’s a bond. You get interest periodically and, at the end of a given period, you get your money back (if the government or corporation is still in business).

But the value of your bond fluctuates while you hold it – that’s an issue if you need to cash it in or sell it before it matures.

Bonds rise in value as interest rates drop. That’s been great for bond investors over the last several years. But as rates rise, the value of the bond drops. With interest rates this low, many people are worried about buying bonds because they think interest rates will go up. If and when rates rise, bonds could get clobbered.

Of course, if you hold on to the bond until it matures, it’s a nonissue. But if you need to sell it prior to maturity, it’s a big issue. Bonds don’t fluctuate in line with the stock market, and that’s one reason why you might want to have bonds in your portfolio.

Neal’s Notes:  As we get older, we become more conservative.  This is only natural.  But it can also be very expensive.  Keep in mind that bonds pay interest but some stocks pay juicy dividends.  Which is better?  Sometimes dividend paying stocks make sense, other times bonds work better and there are other instances where neither really fit the bill.

3. Stocks

You can own stocks outright or do so by owning mutual funds. When you buy stocks, you own a small piece of a company. If you buy a Vanguard fund (for example), you don’t own a piece of Vanguard. You own several pieces of the companies that Vanguard buys inside the fund you bought. Of course, it’s critical that you know how to evaluate a mutual fund or stock before you buy it.

Over the short term, stocks (and funds that own stocks) fluctuate quite a bit. While that’s true, remember that you’re going to be retired for a very long time (hopefully). And that’s the key (which I’ll get to shortly). Over the long run, stocks and mutual funds that own stocks can be a wonderful retirement income investment.

You can create retirement income from stocks by simply selling off a few of those shares every year. For example, let’s say you invest $50,000 in a fund and you want to withdraw $2,500 every year or 5% of what you invested. At the end of the year, you can simply sell off $2,500 worth of the fund. But what if the fund doesn’t earn $2,500?

That’s right. It could earn lots more than $2,500. In that case, just take out your $2,500 and congratulate yourself for being an investment guru. Oh wait…you mean, what if it earns less than $2,500…right?

Well in fact, we’ve had lots of examples lately of funds earning a whole lot less than 5% each year. That’s why you have to consider these investments to be very long-term.

There will be years in which your funds earn less than 5% or even lose money. But there will be other years when your fund will earn much more. Over many years, investing in a portfolio of great funds is one of the smartest things you can do if you’re looking for a retirement income solution.

Now the trick of course is to avoid making catastrophic investment mistakes – like putting all your money into one stock just because your brother-in-law tells you it’s a “sure thing.” Or piling everything into gold stocks because all your friends tell you to do so.

Another important landmine to avoid is to have all your savings invested in equity.  There have been numerous studies that indicate you’ll get about the same long-term return with much less risk by keeping at least a portion of your money in bonds.

There are other investments like real estate, collectibles, commodities and even buying an existing small business. These are all possible ways to increase your retirement income.  And if your cash is limited and you don’t really have as much money as you need to invest to create the income you want, consider alternative ways to create an income stream.  Start slow but start now.  Before you know it, the cash flow could be even greater than you thought you’d earn from your investments.

Each of these offer real benefits and drawbacks. Most retirees don’t find these alternatives attractive unless they have special skills and experience. I’ll discuss those options in later posts.

What investments do you think make most sense to create retirement income?



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{ 1 comment… read it below or add one }

Financial Samurai January 13, 2011 at 8:15 PM

I really think the main thing is proper asset allocation. Once you got that, it’s all good!


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