When you first retire, you face a unique risk: the risk of a market crash early in your retirement. Known as sequence of returns risk, it can obliterate your portfolio before it has a chance to compound high enough to reach “escape velocity.”
As you approach retirement, it makes sense to start reducing risk in your portfolio. Still, you need to strike a balance between reducing risk while still positioning your portfolio to grow and compound.
Explore the following options to reduce risk as you near and enter retirement.
“Reducing risk” doesn’t mean you drop risk — along with your returns — to zero.
Rather, it means shifting your asset allocation to move some of your higher-risk investments to low- or medium-risk investments. Bear in mind that your asset allocation is not static: it should evolve over time to keep pace with your needs.
The following investments come with little or no risk. They shouldn’t make up your entire portfolio, or even necessarily the majority of it. But as you enter retirement you can reduce your risk exposure by moving some of your money into these low-risk investments.
1. U.S. Treasury Bonds
It’s hard to imagine a scenario where the U.S. government defaults on paying its bonds. At least, a scenario that doesn’t involve zombies or aliens or the apocalypse.
That makes U.S. Treasury bonds among the safest investments in the world. As such, they pay among the lowest bond interest rates in the world.
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 it “matures,” at which time the bond issuer pays back the original principal amount.
You can buy and sell bonds on the secondary market through your brokerage account, but most retirees simply hold them to collect the interest payments.
With Treasury bonds, the real risk lies in inflation rather than default. If inflation runs higher than the interest rate paid by a bond, the bondholder actually loses buying power from their investment.
2. Treasury Inflation-Protected Securities (TIPS)
The Treasury Department issues a specific type of bond designed to protect against inflation. These Treasury Inflation-Protected Securities or TIPS adjust in value based on the inflation rate.
The interest rate stays fixed, but the principal value adjusts. If you buy TIPS for $1,000, and inflation runs at 4%, the principal value adjusts upward by 4% to $1,040. Then these securities pay interest on the higher principal value.
Again, don’t expect to get rich off TIPS. They tend to pay extremely low interest rates.
3. U.S. Savings Bonds
United States savings bonds work similarly — but not identically — to standard Treasury bonds.
Both are issued by the Treasury Department, both are backed by the full faith of the US government, both pay low interest rates. Both are exempt from state and local income taxes, although investors must pay federal income taxes on both.
However U.S. savings bonds don’t trade on the secondary market: you buy them directly from the Treasury Department and register them with your name. You can even buy them directly with your tax refund.
Savings bonds come in two types: Series I bonds and Series EE bonds. Series I bonds adjust for inflation, similarly to TIPS. Series EE bonds pay a fixed interest rate, which gets automatically added onto the bond’s principal value in a form of automated reinvesting.
Consider U.S. savings bonds an alternative to Treasury bonds, not an addition.
4. Municipal Bonds
Governments at every level borrow money by selling bonds, and that includes local governments.
Municipal bonds come with slightly higher risk than federal bonds, because local governments can and occasionally do go bankrupt (Detroit comes to mind as a major city in recent memory). However they pay higher interest rates to compensate for that risk.
Investors also enjoy hefty tax perks on municipal bonds. They pay no federal income taxes on the interest, and usually no state or local income taxes either. That makes them an attractive investment, particularly for higher earners as they near retirement.
The lack of taxes on municipal bonds changes the effective return on them. Investors calculate taxable equivalent yield to compare their earnings to after-tax earnings on other investments.
Annuities sound complicated, but they’re really just an insurance policy against running out of money before you die (superannuation).
You buy annuities with either a lump sum payment or a payment plan, and they start making regular payments to you once you retire.
Annuities may return a fixed rate for a specified length of time, possibly for the rest of your life, 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.”
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 you paid while working). The flexibility of annuities works well for an investor approaching retirement, since you 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.
Many personal finance pundits (myself included) share a skeptical view on whether annuities make a good investment. Annuities are expensive, and if you need funds during the surrender period or before retirement age, the insurance company may charge you significant surrender charges or other fees.
Still, they sometimes make sense for certain people and situations. Consider them an insurance policy against complete financial devastation, rather than an investment likely to earn a strong return.
6. Cash Value of Life Insurance
When you buy a whole life insurance policy, it comes with a cash value that rises over time. If structured right, you can use it as a source of borrowing capital for “infinite banking,” and possibly even decent returns over the course of decades. The cash value of your policy grows tax-free, as an added benefit.
Even so, not everyone needs life insurance. And many people don’t structure their life insurance policies well as a long-term investment, either.
Even if you do need or want life insurance, raise a wary eyebrow when insurance salespeople try to push expensive policies on you. The risk of default is low, but the returns are usually low too. In most cases, you’re better off investing your money elsewhere.
7. Home Equity: Eliminate Mortgage Debt
When you pay off your mortgage, you lower your living expenses, and therefore need less money saved for retirement. It reduces your dependence on pulling money out of your nest egg, which reduces your risk and exposure to a market crash.
Consider paying off your mortgage early to earn a return on investment by avoiding future interest. It’s the ultimate “safe” investment: you earn a guaranteed return equivalent to your loan interest rate. It particularly makes sense if you plan to age in place, although home equity is useful regardless. When you go to move, you’ll walk away with a larger paycheck.
Bear in mind that you can also draw income from your home in retirement through a reverse mortgage. It offers another contingency plan for funding your retirement. But you need home equity to qualify.
Low- to Medium-Risk Investments
Risk is not always easy to quantify, and it comes in many forms.
Historically, financial advisors have labeled the following investments as higher risk than those above. But in some circumstances, they can offer both lower risk and higher returns.
For example, as an experienced real estate investor I find far lower risk in my rental properties than the risk of overpaying for a whole life insurance policy that benefits the company more than me. And I worry more about inflation-corroded bond returns than I worry about blue chip stocks failing to pay their dividends.
Before you invest in any asset, just make sure you understand all the risks, along with all the potential upsides.
8. Corporate Bonds
Corporations also sometimes borrow money by selling corporate bonds. Expect both higher risk and higher returns than government bonds.
If you decide to go this route, invest in only established companies with a strong track record, if you want a relatively low-risk retirement investment. Otherwise, you run the risk of discovering firsthand where the term “junk bonds” originated.
9. High-Dividend Stocks
Some stocks produce returns in two ways: in addition to price growth, they also pay out regular dividend income.
Dividend-paying stocks tend to be large, “blue chip” companies with a long history of success. That reduces the risk of them going bankrupt on you, of course. But the dividend income also reduces your sequence of returns risk, because you don’t have to rely on selling off assets to generate income. The stocks pay you regular income, so you can keep them and let your portfolio keep growing.
For especially reliable dividend stocks, check out dividend aristocrats. These companies have consistently raised their dividend every year for at least 25 years. If you don’t want to buy stocks individually, consider buying shares in an exchange-traded fund (ETF) such as the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which includes all of them.
You can also research other high-dividend, low-volatility ETFs. Examples include the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) and the Invesco S&P SmallCap High Dividend Low Volatility ETF (XSHD).
For even more diversification, consider including ETFs or mutual funds from other developed countries, in addition to the U.S. Avoid emerging markets however, if you’re looking to reduce your risk entering retirement.
10. Master Limited Partnerships (MLPs)
Master limited partnerships (MLPs) are a type of limited partnership that are publicly traded.
While MLPs run the gamut across industries, the majority of the hundred or so MLPs trading today revolve around 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 because they are essential to the power companies or refineries, which in turn provide essential products to the public.
Due to quirks in how MLPs are taxed, most distributions are tax-deferred. The entities themselves aren’t typically taxed, enabling them to pass on more profits to investors. Read more about the tax benefits of MLPs to get a better grasp of how returns can impact your tax bill.
The major disadvantage of a MLP lies in the niche focus. Since most MLPs are concentrated in the energy sector, their prospects follow the industry’s fortunes. In other words, when demand slows, so too do their profits and distributions.
11. Real Estate Investment Trusts (REITs)
Another high-dividend option, real estate investment trusts are companies that either own property directly or lend money secured against real estate.
Publicly-traded REITs must pay out at least 90% of their profits to shareholders in the form of dividends. If that sounds great for shareholders, bear in mind that it restricts their ability to reinvest profits in buying new properties or other growth opportunities, so they tend not to see much price growth.
Still, they offer another source of dividend income, which again helps you avoid selling off any shares.
12. Crowdfunded REITs
Crowdfunded REITs don’t trade on public stock exchanges. Instead you buy shares directly from the companies themselves. That limits volatility — a form of risk — but it also limits liquidity. You can’t necessarily sell shares when you like, and the company might hit you with a penalty if you sell shares back to them within the first few years of investing.
But real estate crowdfunding comes with plenty of advantages. To begin with, these companies don’t fall under the same regulation as publicly-traded REITs, which allows them to reinvest their profits in expanding their portfolio if they choose. That can lead to stronger share price growth long term. See Diversyfund as an example of a private REIT pursuing aggressive growth.
Many also still pay high dividend yields. For example, Fundrise pays dividend yields in the 4% to 7% range, and Streitwise pays dividends in the 8% to 9% range. I have money invested with both and have been happy so far with the results.
13. Crowdfunded Real Estate Loans
Not all real estate crowdfunding platforms offer pooled funds. Some instead let investors pick and choose individual loans to fund.
But GroundFloor doesn’t have millions of dollars just sitting around in a vault somewhere to lend these house flippers. They source the funding for these loans from investors like you. You can invest in any particular loan, graded by risk and interest rate, for as little as $10.
Occasionally a borrower defaults. But as a hard money lender, GroundFloor lends a relatively low percentage of the purchase price. So if a borrower defaults, they simply foreclose to recover their — your — money. Besides, when you can spread your money across hundreds of loans, an occasional default won’t crush your returns.
There are a couple other risks in the model, both modest in my view. If the U.S. housing market collapsed, anyone with money tied to real estate would be affected. I don’t see that as likely for the foreseeable future. The other risk is that GroundFloor runs off to a third-world country with all of our money; again, unlikely.
14. Rental Properties
While indirect real estate investments can offer strong returns with no labor, some people prefer to own properties directly.
Rental properties offer predictable returns, tax benefits, protection against inflation, and ongoing income without having to sell off any assets. With experience, they also offer strong returns and low risk.
Which raises the downsides: they require expertise and labor to invest in, and expertise and labor to manage month in and month out.
Only consider investing in rental properties if you have a genuine interest in investing in real estate as a side business. It takes time to build the expertise needed to invest with low risk and high returns, and not everyone wants to spend their time on doing so.
A Rough Guide to Preparing Your Portfolio for Retirement
I’m not a Certified Financial Planner or an investment advisor. You should speak with an expert before you rearrange your entire investment portfolio.
That said, I can offer a few broad ideas around strategy for preparing your portfolio for retirement.
As a general rule, move your investments out of emerging markets if you’re invested there and into developed economies. If you want to take this rule to its logical extreme, move all your money into U.S. investments, although I actually feel this increases your risk rather than reducing it, given the lack of diversification.
Likewise, shift some of your money out of small-cap stocks and into large cap-stocks. Move away from individual stocks and put your money into index fund ETFs. Take advantage of tax-advantaged retirement accounts such as IRAs and 401(k)s.
You can also start buying more bonds and fewer stock funds, and even selling some stocks in order to buy bonds.
I personally dislike and distrust the low yields on bonds, so I opt for diversified real estate investments as a higher-yield alternative. Granted, I have a higher risk tolerance than most, as one of the many hidden benefits of pursuing financial independence and retiring early (FIRE). I can continue investing for high returns because I will continue working long after I could technically afford to stop.
Of course, you can keep working too. Consider reducing your dependence on your nest egg by working a post-retirement gig. By doing so, you can weather fluctuations in financial markets, and therefore leave your money invested in higher-risk, higher-return investments longer.
Far too many people think about retirement in antiquated, black-and-white terms.
Sure, you could work until you turn 65, have a big party at the office, and go from working full-time to not at all. Or you could aim for financial independence at a younger age, coupled with shifting your work to better meet your needs and wants. Because when you no longer need the high paycheck or the fancy job title, it opens up endless possibilities for work you love, on your own schedule, and potentially from anywhere in the world.
I got serious about saving and investing to replace my active income with passive income when I was 37. I hope to accomplish that feat by age 43.
But I’ll keep working for decades to come — on my own schedule, even as I spend 10 months each year traveling abroad with my wife and daughter. Why would I ever retire, when I get to do work I love on my own terms? Which in turn allows me to keep investing for high returns without fretting too much about short-term risk.