Whether you are retired or thinking about retirement soon, the creation of income will most likely be on the top of the list. Now that the paycheck is gone and social security is not filling the gap, retirees must create their own income stream.
For decades, the primary source of this needed income was created by lending funds to banks, businesses or the government, and using the interest received as the income to meet monthly expenses. For the last several years, this has become more challenging due to interest rates remaining very low. The amount of income created from $100,000 this year might be $2,500, when in prior years the earnings may have reached $6,000 or more. This is a significant drop in earnings and I presently do not see interest rates on CDs or other investments reaching the five or six percent level for a while.
One of the most traditional way to manage income when certificates of deposit or bonds are used, is the creation of a laddered portfolio. Picturing a ladder and using each rung as a different maturity, either CDs or bonds are purchased matching the maturities assigned to each rung. As an example, using a ladder with eight rungs, the following table shows the maturities that could be used.
1 3 Months
2 6 Months
3 1 Year
4 18 Months
5 2 Years
6 30 Months
7 4 Year
8 5 Year
With current interest rates as low as they are and the expectation they may start rising soon, the maturities used could be closer together. In this case, the longest maturity might be three years. Thus, as interest rates increase, when each CD or bond matures, those funds would be reinvested at the long end of the ladder. When rates are at a high point, the long end of the ladder may be a maturity of eight years.
By varying the overall length of the ladder, short when rates are low and long when rates are high, the average yield should be much better. Depending upon the size of the portfolio, this can become complicated and you must remember to allow for emergencies.
The advantage of a laddered portfolio using CDs or bonds is that it is conservative. Provided each investment is held to maturity, the principle should be returned. Remembering though, bond values do fluctuate as interest rate changes and if corporate bonds are used, the risk of the business comes into play. However, this type of income stream can create significant problems in the future. The first is the loss of purchasing power over time. Since the principle does not grow, a CD maturing in five years will buy less than when the investment was made. Secondly, interest rates can remain low for extended periods of time thus the loss of income may cause standards of living to be lowered, or the eventual use of principle to meet monthly obligations.
Today’s tax law favors the use of stocks to create income. Creating a diversified portfolio of individual stocks can create income paying a higher yield than CDs. There are many well known companies with dividend yields much higher than one, two, and even three year CDs. But, risks associated with owning stocks come into play.
Some investors are using REITs (real estate investment trusts) to add income to portfolios. These are exceptional tools, but clearly understanding them is a must. The income is not guaranteed and unlike other investment choices, the shares are not generally marketable. Thus when cash is needed, you will need other sources to tap since these shares are not sold easily. Limiting the total amount allocated to REITs should improve income while avoiding a liquidity crunch.
Variable annuities can also be used to create income since they have added guarantees to their contracts. These contracts are complex and not every advisor is equipped to sell them and then manage them once sold.
The best solution may be a blend of all four. Allocating a portion of the investments to conservative CDs or bonds, and then mixing in stocks, REITs, and even variable annuities may create the income needed to live, and the peace of mind to sleep.
For assistance with insurance, estate planning, and managing investments, contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, you can also view our learning center on our website, www.goqfc.com. There you will find articles on a variety of topics, on-line seminars, calculators, as well as a host of other free tools.