On the road to retirement, the investments you relied on to build a retirement portfolio may not be the best solution for generating a retirement income.
If you’re like most retirees, you’ve worked hard saving through your 401 (k) plan, IRAs, or Roth IRA accounts. Most company-sponsored retirement plans offer a mix of mutual funds made up of stocks and bonds. Some of the more growth-oriented funds are likely to have more stocks, while the more income-oriented funds are likely to have more bonds. These options were solid while you were in the accumulation phase.
For many years, conventional wisdom in retirement planning has centered on a simple, balanced stock and bond portfolio that slowly evolved into more bonds and fewer stocks over time. The rationale for making such a recommendation was that this type of portfolio creates less volatility, less growth potential, and offers more income as retirees get older.
Today, this conventional wisdom may not work well for many retirees. This is because extremely low bond yields generate very little returns while increasing the volatility of the portfolio. If you buy bonds or pension funds at current low interest rates, those bonds will lose value if interest rates rise in the future.
If you can’t rely on bonds or retirement funds to generate a decent income and lower the risks in your portfolio, it doesn’t make sense to rely on them as the main building block of a retirement income portfolio.
If you can’t rely on bonds or pension funds, there are other ways to fill that void. This is where alternative assets come into play. Possible alternatives that we will examine are real estate, options, and fixed index annuities.
What are alternative assets?
An alternative investment is a financial asset that does not fall into any of the traditional asset classes. Traditional categories include:
- Stocks like mutual funds or exchange-traded funds.
- Bonds like mutual funds or ETFs.
- Cash, a category that includes money market funds.
Alternative investments usually have a low correlation with those of standard asset classes. This low correlation means they can often generate returns regardless of market direction. This feature makes them a suitable tool for diversification.
Alternatives have many other advantages, including hedging against inflation, where prices tend to rise over time. Alternatives can reduce portfolio volatility and, in today’s interest rate environment, potentially increase portfolio returns.
Alternative assets can also add needed income to retirement income portfolios while reducing risk.
Of course, alternatives have their drawbacks. They can be less liquid than traditional investments like stocks and bonds, which means that if you find yourself in a financial emergency, these investments can be difficult to convert into cash. You are also not immune to downturns – not an investment. They can be more expensive than stocks and bonds depending on the alternatives you choose and where you can get them.
With that in mind, here are three strategies you can use to diversify your retirement income portfolio.
Diversification strategy # 1: Real estate offers income and tax advantages
As an asset class, real estate has the potential to benefit from retirement income portfolios with adequate employment. You can invest in real estate locally by buying houses or apartments for long-term or short-term rental. You can also invest in real estate in real estate in any area of the United States or the world through publicly traded or non-publicly traded real estate investment trusts (REITs).
There are also several property types to choose from, including office buildings, shopping malls, residential and industrial buildings. Whether you invest in real estate locally or through publicly registered vehicles like REITs or funds that REITs own, real estate can offer a steady stream of income and significant tax breaks.
Before investing in real estate, consider the disadvantages. When you buy individual properties, properties can be illiquid and leveraged. That means it can be difficult to sell to convert to cash, and you may need to borrow money to buy the real estate you’re interested in. When you buy REITs or REIT funds, they can suffer from downturns in the real estate market, reducing the income you receive and depressing the value of the stocks.
The easiest way to invest in real estate is through publicly traded REITs that are traded on the stock exchange. The main disadvantage of these types of REITs is volatility. While the purpose of an alternative asset is to add diversification, it is wise to look for an asset that will also reduce volatility. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you’re trying to achieve.
Instead, consider non-publicly traded REITS. They often have a much lower correlation to the stock market because they don’t trade like stocks. They derive most of their value from the underlying properties themselves, rather than from stock prices in the stock markets. This in turn reduces volatility and increases consistent returns.
Diversification Strategy # 2: Options Provide Additional Income
Options are a type of derivative financial instrument with a value based on an underlying asset such as stocks. There are many ways to use options. Within a retirement income portfolio, options offer the potential to increase income while reducing risk.
One option strategy that can be productive is to take advantage of the natural time decay of short-term options. You see, when trading options you can be a buyer who is often viewed as a speculative investment or a seller who is often viewed as a premium collector.
A premium collection strategy is known as a credit spread strategy. This strategy can be complex and risky, but it can also generate regular income if traded successfully. By collecting option premiums as you sell, you can potentially benefit when the value of options declines, which is a measure of time decay. The goal is to collect rewards and not have to return them and the option to expire worthless. In that case, you keep all of the reward you received. If not, losses can occur. This strategy can generate additional income without facing rising interest rates. Additionally, you can target probabilities, a probability of success that you are most comfortable with. This kind of flexibility is difficult to find in other systems.
Options are highly liquid, which is a desirable attribute for a retirement income portfolio. Options also have their drawbacks, including the potential to lose capital and taxes as short-term capital gains.
Diversification strategy # 3: Fixed indexed annuities protect against market downturns and generate income
Fixed Indexed Annuities (FIA) issued by an insurance company are a contract between investors and insurance companies. As an alternative to bonds or annuity funds, FIAs offer deferred tax growth, downside protection, and regular sources of income.
Because FIAs are a product of an insurance company, they can offer the potential to make some stock market profits while avoiding stock market losses. They can also offer a guaranteed income in retirement. Unlike bonds or annuity funds, partial distributions known as free withdrawals are common contractual guarantees for fixed indexed annuities that allow access to a portion of the account value each year that can be used to pay ordinary household bills. This replaces the need to potentially liquidate bonds at a discount in an environment of rising interest rates, thereby reducing interest rate risk.
FIAs can be complex products that provide additional options – called drivers – that can provide you or surviving spouses with, among other things, a lifelong income and an ongoing income in the event of age-related incapacity. These drivers pay in addition to the underlying cost of the annuity.
Annuities can be expensive if they are not structured properly. They also have limited liquidity, which means that your money is tied to the company for a period of time and not available for other expenses. Before purchasing an FIA, make sure you fully understand the regulations, the time required, and any associated fees.
One last word
Alternative assets offer the potential to reduce volatility, improve cash flow, improve diversification, and increase returns, depending on how they’re used in a retirement income portfolio. Using any or all of these techniques can help you achieve more diversification, reduce risk, and earn more income in retirement.
Investment Advisor Agents and investment advisory services offered by Royal Fund Management, LLC, an SEC registered investment advisor.
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Co-founder of Tru Financial Strategies
Nathan Chapel is the co-owner and co-founder of Tru Financial Strategies. Since starting in the insurance and finance industries in 2009, he has had the opportunity to help hundreds of people with their retirement needs with the mantra “Protect Your Wealth, Care For Your Future”. Nathan holds a Series 65 securities license and acts as an escrow advisor.
Co-founder of Tru Financial Strategies
Scott Svoboda is the co-owner and co-founder of Tru Financial Strategies. Since starting the insurance and finance industry in 2012, he has had the opportunity to help hundreds of people with their retirement needs with his mantra, “Protect Your Wealth, Take Care of Your Future”. Scott holds a 65 series securities license and acts as an escrow advisor.