Some types of investment income are more reliable than others. When it comes to retirement income there are many different approaches you can take as far as how to use income producing investments.
I find it helpful to break investment income into three categories: predictable, variable, and guaranteed. Each has its pros and cons.
Predictable Investment Income
Interest income from corporate bonds and dividend income from stocks are two good examples of predictable investment income. These sources of income can be relied upon in most circumstances, but they are not guaranteed.
You can create a fairly reliable source of retirement income by buying interest and dividend paying investments, or by buying mutual funds that own such investments.Dividend income is paid by:
Interest income is paid by:
- Bonds and Bond Funds
- Certificates of Deposit
- Money Market Funds
- Other Safe Investments
- High Yield Investments
- Income From Selling Covered Calls
Many people plan on retiring, buying a portfolio of income producing investments, and living off the interest. This may work, but there are several things to keep in mind.
- Income producing investments like stocks can lower there dividend payout rate. When they do the share price will drop.
- Bonds can default, or when they mature you may not be able to buy new bonds with an interest rate as high at the old ones.
- Investments may not produce enough income to meet your spending needs in retirement.
- It can be tempting to go for high yield investments. These come with higher risks. In addition many investments with higher payouts have these higher payouts because with each distribution they are returning a small bit of principal.
Many retirees can have a more comfortable retirement by creating a plan that allows them to spend some principal in addition to their investment income.
Variable: The Total Return Approach
One way to create retirement income is to build a total return portfolio consisting of cash, fixed income and equities.
The cash and fixed income form the "safe" part of your portfolio. They will generate current investment income in the form of interest. The equities form the growth portion of the portfolio, which allows your future investment income to increase with inflation.
There are capital preservation rules and withdrawal rules that need to be followed when creating this type of portfolio. The income generated will vary from year to year, but you won't be relying on the actual income the portfolio generates each year. Instead the portfolio is designed to achieve a target rate of return, and you will set a withdrawal rate that is less than that target return.
If you don’t want to create your own portfolio, you can use a retirement income fund. These funds typically follow a total return approach.
The total return strategy is effective if you follow a diversified and disciplined approach with regular rebalancing. A total return strategy can be layered over a base of guaranteed income that creates a layer of safety; which can be quite important for peace of mind in retirement.
Guaranteed Investment Income
Guaranteed investment income is exactly what it sounds like; income that is guaranteed by either the U.S. government, or an insurance company. Safe investments like certificates of deposit, treasury securities and fixed annuities are the primary sources of guaranteed investment income.
One risk with using only safe investments is that they will lower their interest rates over time. If you look at a history of safe investment returns like CDs, you can see that the income generated can vary quite a bit from year to year - which means it can't be counted on for your full number of retirement years.
There are several ways you can purchase guaranteed income that can be counted on:
- The most common way to purchase guaranteed investment income is by purchasing an annuity.
- If you took social security early you may be able to repay benefits and essentially purchase a higher future benefit amount.
- Your employer sponsored pension plan may allow you to purchase years of service so you qualify for a higher benefit.
Guaranteed income makes an excellent foundation for a more comprehensive retirement income strategy.