Retirement Funds: Invest Or Save?

Retirement planning is a complex process that requires careful consideration of various factors, including investment options, tax implications, and future goals. While it may seem daunting, starting early and seeking professional advice can make it more manageable and increase your chances of a comfortable retirement. Here are some key points to consider when deciding whether to invest or use a retirement fund:

- Social Security Benefits: Social Security benefits typically replace about 40% of pre-retirement earnings, and higher earners may receive only 33%. Therefore, it is essential to supplement this income with a pension, savings, or investments.

- Investment Options: There are several investment options to generate income during retirement, including bonds, annuities, and income-producing equities. Each option has its own risks and benefits, so it is crucial to understand them before making a decision.

- Tax Advantages: Retirement accounts like 401(k)s and IRAs offer tax advantages, such as tax-deferment or tax-free withdrawals. Utilizing these accounts can help maximize your savings and reduce tax burdens.

- Employer-Sponsored Plans: If your employer offers a retirement plan, such as a 401(k) or 403(b), take advantage of it, especially if they provide matching contributions. This can boost your savings significantly.

- Time Horizon: The time until your retirement is a critical factor in deciding how to invest. If you are further away from retirement, you may want to focus more on growth and take on more risk. As you get closer to retirement, shifting towards less risky investments while still aiming to beat inflation is advisable.

- Diversification: Diversifying your investments across different asset classes, such as stocks, bonds, and cash, can help manage risk and maximize returns. Mutual funds, index funds, and ETFs are popular options for achieving diversification.

- Professional Advice: If you need guidance, consider consulting a financial professional or a robo-advisor. They can help you understand your options, assess your risk tolerance, and create a retirement plan tailored to your goals.

Social Security and post-retirement work

Social Security retirement benefits are a crucial component of retirement planning, but they typically replace only about 40% of pre-retirement earnings for individuals earning less than $100,000 annually. For higher earners, this percentage drops to 33%. This disparity underscores the importance of supplementing Social Security benefits with additional income sources, such as a pension, savings, or investments.

One option to enhance retirement income is to continue working after retirement, whether full-time or part-time. This decision can have financial and mental benefits, keeping individuals active and engaged in their communities. Moreover, working during retirement can lead to higher Social Security benefits. The Social Security Administration reviews the records of beneficiaries with reported wages and recalculates benefits accordingly. If your latest year of earnings is one of your highest, your benefit will be adjusted upwards, and this increase will be retroactive to January of the following year. However, if you are under full retirement age, earning more than the yearly limit will result in a reduction of your benefits by $1 for every $2 you earn above the limit, which is $22,320 for 2024.

When you reach full retirement age, there is no longer a limit on how much you can earn while still receiving your full benefits. It's important to note that your benefits may be subject to taxation, especially if you have additional income sources. If Social Security is your sole source of income, your benefits are unlikely to be taxed. However, if you receive income from pensions, individual retirement accounts (IRA) distributions, capital gains, or job earnings, you may face additional taxes.

To optimise your retirement income, it's advisable to consult a financial professional who can guide you based on your specific circumstances, risk tolerance, and time horizon. They can assist in determining the most suitable retirement income strategy and ensuring your future income streams keep pace with rising living costs.

Annuities

There are several types of annuities:

• Fixed period annuities pay a fixed amount at regular intervals for a definite length of time.
• Variable annuities make payments that vary in amount for a definite length of time or for life. The amounts paid depend on variables such as profits earned by the pension or annuity funds or cost-of-living indexes.
• Single-life annuities pay a fixed amount at regular intervals during the annuitant's life, ending on their death.
• Joint and survivor annuities pay a fixed amount to the first annuitant at regular intervals for their life. After they die, a second annuitant receives a fixed amount, which may be the same or different from the amount paid to the first annuitant, for the rest of their life.
• Qualified employee annuities are a retirement annuity purchased by an employer for an employee under a plan that meets certain Internal Revenue Code requirements.
• Tax-sheltered annuities are a special annuity plan or contract purchased for an employee of a public school or tax-exempt organisation.

The benefits of annuities include:

• A steady, predictable source of income in retirement, regardless of market fluctuations.
• Tax-deferred growth and tax-advantaged income.
• Flexibility in how you save for and receive money in retirement.
• The potential for payments to continue for beneficiaries after your death.

However, there are also challenges and risks associated with annuities. These include:

• Liquidity may be limited.
• Withdrawals from annuities before the age of 59 1/2 may be subject to a 10% tax penalty.
• Guarantees are subject to the claims-paying abilities of the underlying insurance company.
• Risks can be higher if your annuity isn’t underwritten by a highly-rated insurance company.

A diversified bond portfolio

Bonds are available in many forms, and a diversified bond portfolio can be a great investment strategy for retirement. You can invest directly in individual bonds, including US Treasury securities, corporate debt instruments, government-issued bonds, mortgage-backed securities, and bonds from overseas markets.

Bond diversification is important because yields vary based on the credit quality of the issuing entity, the duration of the bond, and current market conditions. Many investors choose to invest in bond mutual funds, a professionally managed, diversified portfolio of bonds from different issuers.

Advantages:

• Steady stream of income with potentially competitive yields
• Liquidity allows for flexibility in making timely changes to your portfolio mix
• Access to a wide range of fixed-income instruments with different yields and risk characteristics
• Provides effective diversification to help offset risk in a portfolio that includes equities and other asset classes

Disadvantages:

• Taxed at ordinary income rates on bond income, except for tax-free municipal bonds
• Risk of principal loss if interest rates rise and the investor needs to sell the bond
• Difficulties in generating comparable income when replacing maturing bonds
• Lack of inflation protection as income streams remain consistent

It's important to note that while bonds are often considered lower-risk, they can fluctuate in value. Additionally, in the current low-interest-rate environment, bonds may not be as attractive for retirement income as they have been in the past.

When deciding whether to invest in a diversified bond portfolio for retirement, it's crucial to consider your risk tolerance, time horizon, and overall financial goals. Consulting a financial professional can help you determine if this strategy aligns with your retirement plan.

Total return investment approach

The total return investment approach is a strategy that focuses on generating income from a diverse range of sources within an investment portfolio, rather than solely relying on dividend or interest income. This approach is designed to provide income, growth potential, and liquidity for retirees.

The basic retirement portfolio consists of three main asset classes: stocks, bonds, and cash investments. Each asset class plays a unique role in the portfolio. Stocks deliver price growth and pay dividends over the long term. Bonds generate fixed coupon payments and help stabilise the portfolio during stock market downturns. Cash and other short-term investments, such as bank deposits and short-term bonds, provide stability, liquidity, and flexibility.

The total return approach aims to have a portfolio that delivers income while growing at a higher average rate each year than the withdrawal rate. This means that even after withdrawals, the portfolio should grow in value over time. This strategy is implemented by setting a targeted annual withdrawal amount and taking that amount from the cash pot, which is filled by interest and dividend payments throughout the year. Any remaining cash after withdrawals is then used to rebalance the portfolio to its target allocation.

One of the benefits of the total return approach is that it can meet immediate cash flow needs while continuing to build savings for future expenses, which are likely to increase due to inflation. It also allows investors to utilise a broader range of assets compared to more traditional retirement income strategies. Additionally, it generates a stream of portfolio withdrawals primarily through capital appreciation, which is often a more tax-efficient form of income.

However, one of the challenges of this approach is that there is no guarantee that funds will last throughout retirement. The value of the returns can vary from year to year, and there is no specific withdrawal rate. In years where investments suffer significant declines, there is a risk that assets may run out before the end of retirement.

When implementing the total return approach, it is important to start with an appropriate mix of investments to provide properly diversified sources of return. Investors should consider their income needs and compare them to the expected income generated by their portfolio through interest and dividend payments. The difference between these two amounts can then be covered through the sale of assets and rebalancing.

Income-producing equities

When considering investing in income-producing equities, it is important to review the company's dividend-paying history. Stocks with a reliable history of consistent or steadily increasing dividend payouts are likely to be the most attractive for this purpose.

Some examples of income-producing equities include:

• Utility stocks: These tend to be attractive to investors who want to generate income from an equity position, and they can help diversify a portfolio made up primarily of stocks and bonds.
• Real estate investment trusts (REITs): These are companies that own commercial, retail, and industrial real estate properties and are required to pay out at least 90% of their taxable income as dividends to investors. REITs usually have higher yields than most blue-chip dividend stocks, but the dividends are taxed as ordinary income.

The benefits of income-producing equities include:

• A regular stream of income paid by companies that generate strong earnings and make consistent dividend payouts.
• The opportunity to benefit from the capital appreciation potential of stocks that also generate income.
• A "built-in return" on your equity investment, represented by dividend income, not reliant on the stock's price performance.
• A diversified source of income for a retirement portfolio; publicly traded REITs provide diversification for a portfolio made up primarily of stocks and bonds.

However, there are also some challenges and risks associated with income-producing equities:

• The principal value of stocks is subject to more fluctuation than other traditional income vehicles such as bonds.
• Not all companies are reliable and consistent in their dividend payouts.
• Stock dividends may become less attractive as interest rates rise.
• Dividend income may be taxed at higher, ordinary income tax rates.

When considering income-producing equities as part of your retirement strategy, it is important to take into account your time horizon and risk tolerance level. A financial professional can help you determine if this is an appropriate strategy for your circumstances.

Frequently asked questions