With age comes wisdom – or, at least, so those of us who are approaching the age of retirement hope. For many people, wisdom includes the recognition that prices of assets can go down as well as up, especially in the short-term. In addition, experience shows that markets do not always reflect underlying values, driven in the short-term more by emotion and psychology than by logic. History is full of companies who have gone public and enjoyed soaring stock prices, only to go bankrupt in the harsh light of economic reality.
When your targeted retirement is three or four decades in the future, losing significant capital on a high risk investment can be overcome. However, as retirement draws closer, investment periods – the time between making an investment and needing proceeds for living expenses – shrink, increasing the possibility that a loss of capital may never be recovered.
As you approach the date on which you will retire, you need to consider whether your current investment strategy makes sense. For example, if you have been an aggressive investor, willingly accepting significant volatility in the prices of your investments in order to capture higher returns, you would be wise to remodel your portfolio to ensure that the maximum amount of capital will be available to you when you retire.
The ideal portfolio should have minimal risk and maximum return – however, ideal portfolios only exist in theory. The following investments for retirement planning are considered appropriate methods to reduce portfolio risk.
Investment Methods to Reduce Retirement Portfolio Risk
1. Bond Ladders
Fixed income securities such as bonds generally do not have investment risk, but are subject to interest rate and credit risk. A bond (usually issued in $1,000 denominations called “par value”) is simply a loan from a government or a corporation that agrees to pay a fixed sum of interest for a period of time until the principal amount is repaid. The level of interest paid by the borrower depends upon its credit risk – the likelihood that the borrower will pay as promised – of the borrower. For example, if Borrower A is deemed less credit worthy than Borrower B, Borrower A will be required to pay a higher rate of interest in order to offset the increased credit risk.
Bonds vary in market value based upon the interest rate of the bond and the interest rate by which new borrowers of similar credit risk can borrow money currently. For example, if an investor already owns a $1,000 bond that pays an interest rate of 6%, while a new borrower with a similar credit rating is able to borrow $1,000 at 4%, the bond with an interest rate of 6% will have a current market price of $1,500, more than the bond with a 4% interest rate ($1,000).
Conversely, a bond with a 4% interest rate in a market where interest rates for issuers of similar quality is 6% will sell for 2/3 of its par value of $1,000 or $667, even though each bond holder will receive $1,000 in repayment when the respective bonds mature. This fluctuation in price is due to changes in interest rates, and is commonly called the “interest rate risk.”
Bond ladders are a portfolio of bonds with similar credit ratings, but different maturity dates. For example, rather than holding a single bond of $100,000 due in 10 years, an investor could purchase 10 positions of 10 bonds each ($10,000), each position maturing one year later than the preceding position. In other words, the investor would receive $10,000 in principal repayment each year of the next decade. As each positions matures, the investor would reinvest the proceeds in a new bond with a 10-year maturity.
Owning a bond ladder protects bond holders from rising interest rates over the next decade. The negative potential of a bond ladder is the possibility of a sustained decrease in interest rates, causing each bond to drop in value if the bondholder is forced to sell rather than wait for maturity.
Annuities are investments purchased from insurance companies. Investments in annuities may return a fixed rate for a specified length of time, or may be invested in market securities, such as mutual funds. The former is known as a “fixed annuity,” while the latter is called a “variable annuity.”
Variable annuities, just like market investments, can lose value. However, many annuity products offer certain safeguards or guarantees on the original amount invested – though often at extra expense. But regardless of the type of annuity invested in, once the investment period concludes (and the investor reaches age 59 1/2), the investor has the option to annuitize the policy by which he or she receives guaranteed payments over a specified period of time (for life, for example) in exchange for the policy value. Or, investors may make make withdrawals following the investment period (or “surrender period”) without forgoing the entire contract value.
Annuities grow on a tax-deferred basis, with each payment consisting of a combination of principal (no tax) and interest (ideally taxed at a lower rate than was paid while working). A person can purchase an annuity during his or her income-earning years, but defer the start of payments until retirement. The flexibility of annuities is particularly advantageous for an investor approaching retirement, since he or she can invest money today, let the principle grow on a tax-deferred basis, and then choose a payment period for a fixed or variable rate of time. However, annuities are expensive, and if the policyholder needs funds during the surrender period or before retirement age, he or she may be subject to significant surrender charges and/or other fees.
Finally, the rates of return earned on the principal may be less than could be earned in other professionally managed accounts. These vehicles can be very effective but are complex, expensive, and can tie up your money for years – speak to a qualified financial advisor before investing in and choosing an annuity.
3. Mutual Funds (Managed Accounts)
Simply stated, mutual funds are professionally managed portfolios of stocks and bonds. While mutual funds have declined in popularity from their heyday in the 1970s and 1980s, they remain a primary investment vehicle for retirement accounts. According to the 2013 Investment Company Factbook, mutual funds accounted for more than two-thirds of all IRA assets and almost half of 401k balances at the end of 2011. Some funds seek aggressive growth, while others pursue safety and income.
If you have been a mutual fund buyer with high growth as your objective, consider exchanging some of your position into less volatile balanced and income funds. Depending upon the fund’s sponsor, you may be able to exchange shares of the aggressive funds for shares in lower-risk funds, with minimal cost or administrative headaches.
The advantages of a professionally managed portfolio include the following:
- An experienced portfolio manager focused full-time on the assets being managed and generally supported by legions of staff.
- The investor’s opportunity to choose specific investment objectives to fit his or her needs, such as high-growth, large cap, balanced growth, emerging companies, and income.
- The ability to regularly invest small amounts of capital over long periods of time. Many private managers require portfolios of $500,000 to $1 million as the minimum they will accept.
Disadvantages of mutual funds include high sales commissions, management fees, and the securities commissions paid for trades of securities in the managed portfolio. There has been some charges in recent years that the typical fund manager is unable to beat market averages over any significant period, claiming that mutual fund returns most likely result from major market movements, rather than individual stock selection.
Nevertheless, the combination of professional management, diversification, and stringent oversight and regulation justify consideration by investors nearing retirement as a method to reduce investment risk by diversification in their portfolios of individual stocks.
4. Exchange Traded Funds
In recent years, investors have flocked to a new investment vehicle: the exchange traded fund (ETF). The asset pools, rivaling the size of the larger mutual funds, are managed only in the sense that the stocks are selected to replicate the movement of a public stock or bond index, such as the S&P 500, the NASDAQ-100 Index, or the Barclays Capital U.S. Government/Credit Index. At the same time, shares can be purchased or sold just like any corporate common stock share.
Depending upon the index that the fund has been designed to mimic, there is built-in diversification. Administrative fees are considerably less than a typical mutual fund, and commissions for security trades by an ETF are much less than the managed mutual funds since the only activity is whatever is needed the bring ETF in line with the index. If, as some claim, a mutual fund’s performance is equal to the market as a whole (the S&P 500, for example), an ETF tracking the S&P 500 would produce a higher net return for investor simply because the fees are generally one-quarter to one-third of the fees of the typical mutual fund.
Investors seeking to reduce their risks with approaching retirement should be especially careful in selecting either a single ETF or a group of ETFs, since indexes can represent high-risk strategies, such as commodity investments, emerging market securities, or world currencies. Ideally, you should “balance the portfolio” by proportioning ETFs with different market characteristics. For example, some indexes rise in value when the economy is in decline, while others rise in line with the economy. A perfectly balanced portfolio would not be adversely affected by a significant move in either direction.
Selecting an ETF that tracks a lower-risk index can reduce overall portfolio risk. Some ETFs worth considering include the following:
- PowerShares S&P 500 High Dividend Portfolio (SPHD), which tracks the S&P 500 Low Volatility High Dividend Index
- SPDR® S&P® Transportation ETF (XTN), which tracks the S&P Transportation Select Industry Index
- Global X Guru Index ETF (GURU), which tracks the Solactive Guru Index
5. Real Estate Investment Trusts
Real estate investment trusts (REITs) are popular with investors due to their concentration in real estate assets. These assets may be mortgages on residential and commercial properties, mortgage-backed securities, or the actual real estate properties such as apartment houses and commercial buildings. Real estate has always enjoyed a number of tax advantages – including depreciation, in some cases, on a super-accelerated basis. For example, an apartment house purchased for $1 million with an underlying land value of $100,000 would be entitled to a tax deduction of $30,000 per year for the next 30 years. This means that profits of $30,000 can be distributed each year without any tax being due.
The trust arrangement also avoids double taxation, which affects corporations and stockholders. Effectively, the corporation initially pays tax on its income and distributes after-tax funds to its shareholders in the form of dividends. Shareholders are then taxed a second time, as dividends are treated as personal income to the individual shareholder.
REITs are not taxed as long as they pay at least 90% of their income to beneficiaries of the trust each year. At retirement, many investors actively seek REIT investment due to this requirement. After suffering through a number of years of recession, many analysts believe that real estate will be in a bullish market in the intermediate term, this making them more attractive for soon-to-be-retired investors.
Real estate, like most asset types, endures cycles of prosperity and decline. Real estate properties are less liquid than traded securities, while mortgage-backed securities continue to be under regulatory fire. Nevertheless, the tax advantages, leverage, and the possibility that a bullish cycle for real estate will begin as the economy continues to recover justify their inclusion in a conservative portfolio. A prudent person would limit total REIT holdings to 20% or less than the total portfolio value with no single REIT comprising more than 10% of the total portfolio.
6. Master Limited Partnership
Master limited partnerships (MLPs) are a type of limited partnership that are publicly traded. While MLPs can be found in a variety of industries and activities, the majority of the approximately 130 MLPs existing today are involved with the transmission of crude oil or natural gas through pipelines. The partnership owns the pipeline and receives a transmission fee based upon volume as crude oil or natural gas flows through the line. In many ways, MLPs are similar in risk to utility stocks since they are essential to the power companies or refineries which, in turn, provide essential products to the public.
An MLP includes a general partner who is responsible for managing the affairs of the partnership, and limited partners who provide capital for the partnership’s activities (such as the construction and operation of a pipeline) but have no management authority (including the right to replace the general partner, except in certain instances), nor financial or legal liabilities stemming from the partnership’s activities. The partnership agreement generally provides for regular distribution of cash flow subject to some restriction. No taxes are paid at the partnership level – any income tax due or excess deductions are passed to the limited partners and taxed at their individual level when distributions are received.
A master limited partnership is similar to a real estate investment trust in that tangible assets can be expensed or depreciated; in some cases, accelerated depreciation (as well as tax credits) can be used for the benefit of the limited partners. This arrangement allows limited partnerships to receive distributions on a tax-advantaged basis. Like REITs, MLPs can be appropriate investments for those seeking lower risk and high income in proportion to their investment capital.
The major disadvantage of a MLP is that its business is very focused. Since most of the MLPs are concentrated in the energy sector, their prospects follow industry results. In other words, when demand slows, their profits and distributions are likely to fall. Some publicly traded MLPs to consider adding to your portfolio to reduce market risk are Suburban Propane Partners (SPH), Targa Resources Partners (NGLS), and PVR Partners (PVR).
Whether you need to adjust your investment strategy this year, five years from now, or never is a personal decision. This decision depends upon your risk tolerance, the variety and amount of your total investments that might be used for retirement, your use of personal professional money managers, and your willingness to invest time and energy keeping abreast of the market and your investments.
Whatever your decision may be, it is wise to keep in mind the following:
- Nothing Lasts Forever. Even the best investments can fall in value.
- You Can’t Take It With You. Hearses don’t come with U-Haul trailers – at some point, you will accumulate enough so that taking any risk is unnecessary and unwise.
- There Is No Free Lunch. If something seems too good to be true, it probably is. Avoid investing in high-return, “guaranteed” schemes – you’ll save money in the long run.
What do you think? Is it time to revisit your portfolio or change your investment objectives?