Most investors know it's wise to spread their money between stocks, bonds and various subcategories. But those in or near retirement may give special attention to organizing income-producing assets like dividend-paying stocks, interest-earning bonds and certain funds designed for big yields.
So, what are the factors that go into setting up the income-producing part of the portfolio?
Bruce Elfenbein, an advisor with SecuRetirement in Hollywood, Florida, has a rule of thumb for retirement investing: "How much money can you afford to lose before it will negatively affect your quality of life in retirement? If you double that number, that's a benchmark for the amount of money you can afford to have at risk."
That way a 50% drop in the market will leave enough to keep up the lifestyle.
As any advisor will say up front, everyone's situation is different. But most retirees share a need to get the most income possible without taking on too much risk.
After all, retirees requiring a given income can be in a very tight spot if they continue taking the same amount after assets have lost value. A portfolio that loses 20% of its value in a market plunge must grow by 25% to get back to where it was, and one that loses 50% must grow by 100%. Reducing the balance by taking more out after a drop just makes matters worse.
The income producers therefore need to be dependable -- to keep paying even if the assets themselves fall in value. Experts say that two of the most important factors in setting up the portfolio for income are diversification and credit quality.
Diversification is the centerpiece of most investment strategies. The idea is for some assets to go up when others go down. Traditionally, stocks and bonds have often moved in opposite directions, though at times they do move together.
For retirees, diversification also means spreading money around within the fixed-income portion of the portfolio. That can be done, for example, by owning bonds of varying maturities, by having a mix of dividend-paying stocks and funds as well as bonds, and by owning municipal and corporate bonds as well as super-safe Treasurys, certificates of deposit and money-market funds.
Ilene Davis, a planner at Financial Independence Services in Cocoa, Florida, says she uses a simple time line to guide allocation for providing cash for the gap between expenses and other income sources like Social Security.
Once an emergency fund is established, she invests enough in certificates of deposit and money market funds to pay two to three years of expenses. To fund the four or five years that follow, she uses a balanced fund containing income-producing stocks and bonds. Money not needed for five to 12 years goes into a slightly more risky, but probably more generous, growth and income funds, and money not needed until after that is invested for growth, which generally means stocks and stock funds.
"Meanwhile, dividends and capital gains can be deposited in a money-market fund to keep it filled," Davis says.
Elfenbein says, "The model that we like to use for retirement keeps approximately 10% of our assets liquid -- in bank savings, checking, money market, etc. -- approximately 65% into guaranteed income products and 25% in the market to account for inflation and future increases in taxes."
Guaranteed income products include things like annuities that pay a fixed income for life. The "market" portion is primarily stocks and stock funds to provide growth. While that entails risk that many retirees try to avoid, hazards can be minimized by not being too greedy.
"As long as you have assets growing greater than the rate of inflation to account for greater need in the future, you should be alright," Elfenbein says .
Diversification can also be accomplished by owning bonds and fixed-income funds of varying credit quality. But advisors say investors depending on income can be wise to favor issues with better credit ratings that will continue paying even if a market downturn drives their prices down.
"I would encourage investors setting up retirement income portfolios to focus on high quality bonds," says Robert Johnson, professor of finance at Creighton University's Heider College of Business. "Investors have been burned reaching for yield by accepting the risk in higher yielding junk bonds. After all, high-yield bonds are called junk bonds for a reason."
Stocks are not rated for quality in the same way bonds are, but dividend-paying stocks from companies that pay consistently and that raise dividends regularly can be a good bet for income-hungry investors, Johnson says.
"The advantage to buying a stock that consistently pays a dividend versus a bond is that bond payments are fixed and don't increase over time," he says. "Dividend-paying stocks not only have a cash flow, but typically that dividend payment increases markedly over time. In addition, stock prices generally rise over extended periods of time."
Duration is a measure of how much value a bond can lose if interest rates rise, depressing the value of older bonds that pay less than new ones. A bond with a five-year duration, for example, will lose 5% of its value if rates rise by 1%. Duration is related to time to maturity and shorter duration means less yield but more safety.
"So, when rates rise, longer duration bonds fall in price more than shorter duration bonds," Johnson says, noting that interest rates today have more room to rise than to fall. "I believe there is currently more risk to investors in the bond market than in the stock market, and this risk is interest-rate risk."
Bonds with longer maturities pay higher yields, but for the moment that premium is not large enough to justify the greater risk of a price drop, Johnson says.
So, seeking income in retirement is always a balancing act between risk and reward. The best advice is simply to look at durations, credit quality and income needs to guide how to spread your money around.
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