Even retirees who do everything right can find themselves coming up short when it comes to affording some of the little luxuries they had planned for their remaining years. Just take a look at Mike and Judy, a hypothetical couple very similar to many retired couples, who saved and invested for decades in order to enjoy a secure yet stimulating retirement.
Mike, 75, and Judy, 72, retired from their stable, remunerative careers a couple of years ago. Mike, an executive with an insurance company, always made a better-than-average wage in the low six figures. Judy did, too, thanks to a long and successful career in hospital administration. They took advantage of their employers’ matching contributions to their 401(k) plans and made annual contributions to their IRAs in order to claim the tax deductions. Together, they have just under $700,000 in retirement savings, roughly the average of what Consumer Reports readers about to enter retirement have accumulated, according to a recent survey.
In other words, Mike and Judy did what they were supposed to do. But now in retirement, they—and many people like them—can’t afford to do all of the things they dreamed of. One of the cold, hard facts of retirement is that even after a lifetime of saving, many retirees face challenges they didn’t expect.
Though even a sizable nest egg may be enough to cover basic living expenses and taxes, you may also have to factor in the cost of Medicare, and supplemental Medicare premiums, co-pays, and deductibles; the cost of long-term care insurance; and prescription drugs. On top of that, some retirees are paying college expenses. And inevitably, there are the unexpected costs that come from health problems or a financial crisis. Social Security helps: People like Mike and Judy can expect about $50,000 in Social Security benefits per year between the two of them.
So what can you do? Fortunately, there are a number of options for generating extra income without taking undue risks. The improving economy certainly helps. And interest rates, which have only one way to go—up—are something that retirees can use to their advantage. Here are some of the best options to generate a steady, low-risk income in a rising-rate environment:
1. Annuities
Not too long ago a number of financial planners and advisers looked askance at annuities. Now they’re more likely to wonder why more people don’t buy them. Yes, in certain cases annuities can be complicated and have pricey fee structures. But that’s not true of all of them. Most importantly, to generate guaranteed income in retirement, annuities are a slam dunk.
An annuity is a contract with an insurance company. In exchange for a lump-sum payment now, the annuity holder receives a guaranteed payout every month for either a fixed term or for the rest of his or her life.
If your biggest fear is that you will outlive your money, an annuity is the ultimate safety net. Be forewarned that you’ll have to work closely with your financial planner or adviser to get the best annuity for your needs. After all, there are 1,600 kinds on the market.
To get a sense of what you can expect to see from a popular type of annuity, consider this: A 60-year-old male making a lump-sum payment of $200,000 could buy an immediate annuity that pays income for life of about $1,000 per month. A $500,000 annuity would generate income of about $30,000 per year.
Of course, there are some downsides to annuities. One can be the fees. Many annuities are sold by insurance brokers who take a commission that can be as high as 10 percent of the amount invested. Instead, opt for “direct sold” annuities from a large brokerage firm, such as Vanguard, where there is no commission. Also, if you pull your money out of an annuity in the first several years after you buy it, you could have to pay a surrender charge that’s often about 7 percent of the account value. Annual fees are also common among variable annuities—they can run about 2 percent or more of your investment per year.
Factor in, as well, the opportunity cost of an annuity. If you sock $200,000 into an annuity, that’s $200,000 you can’t invest in anything else, such as a fast-rising stock market.
Annuities are illiquid—meaning they are hard to turn into cash when you need it—so they should be used for only a portion of your savings. There may be no guarantees in life, but adding an annuity to a multifaceted retirement portfolio is the closest you can get to a sure thing. No matter what happens, those checks will keep coming.
Consumer Reports' Retirement Planning Guide offers expert, unbiased advice on making the most of your next life chapter.
2. Bond funds
Often, passive investments such as exchange-traded funds and index mutual funds are the best way to go for most investors. They have the lowest costs and are never going to underperform the market or a relevant benchmark. By comparison, actively managed funds are more expensive and often fail to perform as well as index funds.
These days, however, retirees should probably embrace at least some the advantages of having an experienced bond-fund manager directing their investments. That’s because when interest rates rise, bond prices fall—a combination that can be scary to investors. Though some investors may choose to sell their investments in such a market, seasoned bond-fund managers will know how to protect the funds and position them for the best possible returns.
Keep in mind that not all bonds react to rising rates in the same way. Short and intermediate bonds aren’t as sensitive to interest rates as longer-term debt is. A bond-fund manager can use that distinction to minimize volatility and maximize returns.
And, of course, higher rates also mean that a bond fund can generate higher yields. That is a critical piece of good news. Yes, the value of a bond fund will fall when rates rise, but that only matters if you intend to sell some of your bond-fund holdings. If your aim is to hold on for years in order to collect the income, rising rates are the best news you can get. Bond-fund yields will grow. Given enough time, prices will recover, too.
Treasury bonds, high-grade corporate debt, municipal bonds, Treasury Inflation-Protected Securities (TIPS), and even high-yield corporate debt (junk bonds) can all have a place in a diversified portfolio of bond funds. Treasuries dampen risk, for example, while corporate debt—especially junk bonds—can boost an income stream.
Examples of diversified bond funds you might want to consider include the T. Rowe Price Spectrum Income Fund (RPSIX), yielding 3.22 percent with a 0.67 percent expense ratio; or the Loomis Sayles Fixed Income Fund (LSFIX), yielding 4.5 percent over the last year with an expense ratio of just 0.57 percent.
3. Certificates of deposit and CD laddering
Few investments have been stripped of their savings power by ultra-low interest rates like certificates of deposit have. So today, they won’t offer you much income. But because CDs are going to be a big beneficiary of rising interest rates, you can incorporate them into a plan to generate income for you in the years ahead.
Any CD sold by a bank covered by the Federal Deposit Insurance Corp. is insured for $250,000. That puts a large cap on risk, but a one-year CD today will offer you a maximum annual percentage yield (APY) of only about 1.3 percent. The highest yielding five-year jumbo CDs (those with a minimum deposit requirement of $100,000) sport an APY of 2.3 percent.
One way to take advantage of rising rates is to construct a laddered CD portfolio. You put an equal amount of money into CDs with different dates of maturity—say, one-year, two-year, three-year, and five-year CDs. As the CDs come due, you take the principal and buy CDs with a longer term. So when the one-year matures, you take the proceeds and buy a five-year CD. A year later, when the two-year comes due, you put that cash into a five-year CD.
By cycling through term lengths that way, you won’t have your entire principal tied up in relatively low-yielding CDs as interest rates rise. Instead, some capital is freed up to invest at higher rates.
4. Dividend stocks
Like bonds, prices for dividend stocks tend to fall as interest rates rise. But it won’t matter to you if you have no intention of selling your dividend stocks. What’s even better is that the yield on a dividend stock rises as its price falls. Heck, anyone looking to buy shares of a dividend stock for a healthy stream of income should welcome a drop in stock prices.
Another benefit of dividend stocks is that any hit they take from rising rates is usually short-lived, and history shows that they usually maintain the potential for price appreciation. Between price and yield, dividend stocks have an excellent long-term track record. Since 1928, dividend stocks have generated average annualized returns of anywhere from 9 percent to almost 11 percent. Non-dividend-paying stocks generated an average annualized return of 8.32 percent. Favorable tax treatment and a long history of dividends growing faster than inflation are other attractive attributes.
You might want to consider dividend mutual funds and exchange-traded funds (ETFs) to diversify dividend stock holdings. You could also create a portfolio offering higher yields. The most popular dividend ETF has a yield of 2 percent, but roughly 33 companies in the Standard & Poor’s 500 Index sport yields of at least 4 percent.
Colgate-Palmolive (CL), Procter & Gamble (PG), and Coca-Cola (KO) are just a few companies that have paid rising and uninterrupted dividends since the 1880s. Any stock that chugged along making rising dividend payments through two world wars, the Great Depression, and the Great Recession is likely to keep the payouts coming through the span of a retirement.
Every one of the above options offers steady income with comparatively little risk. If our couple, Mike and Judy, put $200,000 of their almost $700,000 in savings into an annuity, that could generate around $12,000 per year. Then they could spread the rest of their nest egg—almost $500,000—among bonds and dividend stocks. At a 3 percent interest rate, that would generate an additional annual income stream of $15,000. Together with the income from Social Security, that would be enough, perhaps, to fulfill more of their retirement dreams.
