This is a continuation on the series on retirement investing. See the first post here.
The goal of investing in a traditional retirement portfolio is to generate enough income to pay for expenses so the principle can be left intact. There must also be a growth aspect to the account to preserve the account value as it is ravaged by inflation and to keep the income level rising enough to keep up with inflation. Ideally one would like enough cash to be generated from income and dividends to meet monthly expenses such that the sale of securities would not be needed. When interest rates are sufficiently high this can be accomplished easily using bonds, high yielding stocks, and perhaps real estate assets.
If interest rates do move back up, the typical retirement investments — those that pay a good dividend — are:
1. Utilities – Because utilities are typically not in a growth phase, but instead simply collecting money from rate payers and distributing the profits to shareholders, utilities typically pay good dividends.
2. REITs – Real Estate Investment Trusts hold a portfolio of real estate, typically concentrated in a certain type. For example, there are REITs that focus on office buildings, apartment buildings, shopping malls, and even cell phone towers. These generally generate good income from rents that are passed along to shareholders.
3. Limited Partnerships – These trade like stocks and are typically tied to some income-producing source such as a big steel ore pit or a set of oil distribution lines. Much of the income received is passed to the partners.
4. Preferred shares – These are special shares of stock that a company issues when it wants to raise money for some purpose. They typically pay a large dividend and can have special features like the ability to convert to common shares at some ratio.
5. Bonds – These are loans made to companies and pay interest twice per year and at some point in the future return the principal to the lender (the bond holder). If interest rates do spike because inflation picks up, as it did in the 1970′s, one could be set for retirement by buying into bonds paying very high rates and then holding onto them as interest rates subside. Bonds are currently paying too low a rate right now, however, due to the low-interest rates on government securities, to be worth the investment.
One option which would require a little more work is to buy rental properties that generate rental income. This is not always the best option since it either requires one to become a landlord/repair man or hire a manager who will take a substantial amount of the profit, but it is a way to raise an income when the interest rates paid by traditional income investment is low or for those who just enjoy owning real estate.
To set up an income generating portfolio, simply diversify among the different options listed above. Rather than having income that is generated be reinvested, as was done when you were younger and didn’t need the cash for expenses, simply have the cash go into a brokerage money market account or direct deposited into a bank money market account. You’ll want to have a little cash cushion in this account – perhaps a year’s worth of expenses – to avoid being short on cash when an expense is due.
If you are investing through mutual funds, things are fairly simple. For example, you could put 25% each in a total bond fund, an income fund (which would invest in both bonds and stocks), an REIT fund, and maybe a hybrid such as a convertibles fund (which would buy convertible preferred stocks and bonds). These should generate income throughout the year which would be deposited in your money market account.
If you are investing in individual securities, you’ll need to structure things yourself to ensure you’ll be receiving income payments as needed throughout the year. Bonds typically pay interest payments every six months, so you may want to buy some bonds that pay in January and June, and then some others that pay in April and September, for example. Most stocks pay a dividend four times a year. Some also pay a large dividend at the end of the year, which is useful for things like home property tax payments. Limited partnerships often provide a small payment throughout the year like a dividend and then provide a large payment at the end of the year, as do REITs.
One final consideration is saving on taxes. If you have the ability to generate more income than you need, you’ll want to avoid paying taxes on income that you reinvest if you can legally do so. One way to do this is to keep assets that generate excess income in your IRA or 401k accounts and then keep most of the equities you own in your taxable accounts. Because the equities only generate taxes when you sell them, you won’t need to pay taxes on gains there so long as you leave them alone to grow.
The assets that generate income needed during the current year can be in a retirement account or in a taxable account since you’ll be paying the same taxes on the income either way if you take and use the money. Note that you are required to withdraw a certain amount each year, as determined by your age after you reach 70 ½ years old. If this is the case, you’ll want your retirement account to generate at least as much cash as needed for the required distributions each year to avoid selling assets.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.