Younger people who are saving for retirement tend to rely mostly on stocks. While stocks are a risky investment vehicle, people who are younger have time for their portfolios to recover should something happen in the market. Moreover, accepting higher risk provides a greater chance of larger returns, so the portfolio can grow quickly.
As you get closer to retirement, your risk tolerance should decrease since you have less time to recover. You do not want to lock in losses. By the time you retire, your portfolio should have minimal volatility, which means investing in bonds and annuities for most people. Bonds prevent most investors from /significant losses even though they limit the growth potential of your portfolio. Fixed Index Annuities remove all downside risk, while offering upside potential in various index choices.
As you transition to guaranteed principal annuities or a larger number of bonds and more conservative portfolio, there are some pitfalls that you need to avoid. These pitfalls include:
1. Ignoring municipal bonds.
Many people use the interest that bonds pay to supplement other income sources during retirement. However, it is important to keep in mind that the interest you receive from corporate bonds is taxable. Thus, you may have a hefty bill at the end of the year if you rely entirely on corporate bonds.
A better strategy involves investing at least partially in municipal bonds. These bonds get issued by the government and work slightly differently than their corporate counterparts. Municipal bonds are always exempt from tax at the federal level. Moreover, if you invest in municipal bonds that get issued by the state you live in, you can also avoid both state and local taxes on interest payments.
Always consider taxes as you look at different bonds. It may be worthwhile to invest in an option that pays less but does not get taxed at all. It is also important to note that, like all other bonds, municipal bonds will fall in value when interest rates rise, so much caution is warranted in buying them in a low interest rate environment.
2. Replacing your entire portfolio.
Another common mistake that people make as they retire is getting rid of all stocks and filling their portfolio completely with bonds. The key to mitigating risk but maintaining some growth is keeping a mix. If you reinvest completely in bonds, your portfolio’s growth will likely cease.
A better approach is to start retirement with a portfolio that is roughly half stocks and half bonds. Anyone who is particularly risk-averse may instead opt for a combination that is 40 percent stocks and 60 percent bonds. These mixtures give some space for continued growth and will help you feel more comfortable with a higher savings-withdrawal rate. Replacing a portion of your stock and a portion of your bond allocations with a fixed indexed annuity that offers nice upside potential, and no downside risk, is an important consideration as well. In the recent strong equity market environment over the past couple of years, we have seen lower double digit returns on fixed indexed annuities for many people, with no chance of suffering a loss. That is a winning combination for peace of mind in retirement for most.
A portfolio that relies completely on bonds may mean that you need to withdraw less each month to avoid running out of money. Ultimately, the right balance depends on your personal needs and comfort level, but it is important to continue promoting growth as much as possible.
3. Trusting bonds without question.
Some investors do not realize that bonds are not all high-quality, low-risk investments. While municipal bonds are largely safe investments since the chances of a government folding are small, corporate bonds can pose a significant risk.
Always do your research before you invest in a bond. If the company is struggling, there is always the chance that the organization will cease to exist and you will not get any further interest payments—or even your initial investment.
Riskier bonds tend to pay higher interest to attract investors. Whenever you see a bond option that pays very high interest, do some investigation to figure out why. If you are transitioning to bonds to lower overall risk, these investments do not make sense. You may want to consider a bond exchange-traded fund since this type of investment comes with built-in diversity and protection.
4. Failing to ladder investments.
One of the risks involved in investing in bonds has to do with interest rates. When you invest in a bond, you lock into a period of time for the interest rate. During this time, interest rates may increase or decrease, which can change the amount these bonds are willing to pay. While you may end up with a higher interest rate at the end of the bond term, you could also get stuck with a lower one.
To mitigate this risk, you should ladder your bond investments. This means staggering them so that they mature at different times. In other words, avoid buying a bunch of 10-year bonds all at the same time. That way, if the interest rate decreases during that period, you are not stuck reinvesting money from several different bonds in an unfavorable environment.
When bonds mature at different times, you may have some reinvestments that pay higher interest and some that pay lower. The idea behind laddering is that everything will even out in the end.
5. Overlooking inflation rates.
Retirees also need to keep a close eye on inflation rates as they can cut into the returns from bonds. Since these returns are generally quite low, they may not even be greater than inflation. This would mean that your purchasing power actually decreases over time.
In the current environment, inflation rates are trending upward. It is important to pay attention and choose a spread of investments that is more likely to break even—and ideally surpass inflation. This may include adding precious metals, commodities and other non-dollar holdings to your portfolio. That way, your money can continue to grow.
Another point to keep in mind when it comes to inflation and bonds is that you should probably focus on short-term bonds that last only a few years. That way, you can reinvest appropriately as the environment changes. If you lock into a long-term bond, you have no choice other than riding out what may be a very low interest rate.