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Risky Income in Retirement

What You Should Know About Income in Retirement

As you approach retirement, you have probably heard advice about steering your portfolio away from growth and towards income in retirement. Although shifting to fixed-income or dividend-producing investments might generate cash flow to fund expenses once you stop working, focusing solely on income in retirement can actually increase your risk, and it pays to consider all the potential dangers. Often, there are other investment vehicles and asset classes that can put you on the path toward achieving your goals.

At Fisher Investments, we can help you learn more about some of the risks associated with income-producing investments, including those that promise high yields. There are many retirement planning strategies, but it is important to understand the potential pitfalls that come with investing only for income in retirement, and to learn about alternative ways to invest to achieve your financial goals.

Less Risk? Not Necessarily

Some investors may associate “income-generating” investments with “safer” ones, but it can be dangerous to get overly comfortable. Every investment has risk, and investments that focus on income in retirement are no different. The risks for income-generating investments can include:

  • Low yields or falling interest rates can lead to income shortfalls, forcing you to dip your principal to cover costs and making it harder to achieve your financial goals. The risk of not reaching one’s long-term goals can be the greatest risk of all.
  • Rising interest rates can make your current bond holdings less valuable.
  • If you focus too much on income in retirement and end up owning too many dividend-producing equities, your portfolio might start to lack diversification, as many equities that pay dividends are concentrated in a few sectors. Even in retirement, it is important to keep a diversified set of investments to lower risk. Additionally, no company’s dividends are guaranteed. They can be cut or eliminated at any time, as investors tend to learn each time the economy and stock market enter a rough patch.

A Closer Look: The Risks of Several Retirement Planning Strategies

Let’s look at several popular income-generating investments and consider some of the specific risks associated with each. Investors should keep these considerations in mind as they craft an investment strategy designed around income in retirement.

Bonds
Bonds can help reduce short-term volatility for investors with cash flow needs. Risks associated with bond investments can include liquidity risk, interest rate risk (rising rates can make current holdings worth less), reinvestment risk (issues with callable bonds and reinvesting bonds at potentially lower rates even if held to maturity) and credit risk. Certain types of bonds have other risks:

  • Investment-grade bonds: These bonds typically have less default risk—particularly bonds that are backed by the federal government. Although they are sometimes considered safer, remember that bond rates fluctuate, and even factoring in recent gains in yields, bond rates are near generational lows. Investors who focus to heavily on income in retirement may find it difficult to reach long-term goals if such low rates of return persist.
  • High-yield bonds: These bonds tend to produce greater yield—but in general, the higher a bond’s yield, the greater the underlying credit risk of the entity offering it.

Dividend-paying stocks
Many investors assume that a stock paying regular dividends is “safer,” but this isn’t true. Stocks aren’t more or less safe because they pay a dividend—and dividends can be cut at any time. Additionally, since businesses in certain sectors may pay dividends more often than others, investors looking for income in retirement through these types of stocks could end up overconcentrating their portfolios in a few sectors like Consumer Staples and Utilities. Investors who lack diversification can find themselves more vulnerable because they haven’t adequately spread out their risk across various market sectors.

Master Limited Partnerships (MLPs)
MLPs were created in the 1980s by Congress, which hoped to generate more interest in energy infrastructure investment. The aim was to create a security with limited partnership-like tax benefits, but publicly traded—bringing more liquidity and fewer restrictions. Because MLPs are generally concentrated in the energy sector, however, investing too heavily in MLPs can concentrate an investor’s portfolio and increase risk. Because MLPs are “pass-through” structures, they can offer occasional tax advantages in taxable accounts:

  • As a partnership, they aren’t subject to corporate taxes.
  • Losses and depreciation can pass through to lower tax burdens.
  • Distributions to unit holders aren't taxed immediately.

Unfortunately, much of this benefit is temporary. Although pass-through deductions can reduce the taxes owed on MLP income, they also reduce the cost basis or amount of the investment. This increases capital gains later, essentially shifting the tax burden until the shares are sold. MLPs can also trigger tax bills in IRAs and other tax-deferred retirement accounts.

Real Estate Investment Trusts (REITs)
REITS are organizations that purchase various forms of real estate, collect rent from leases, or collect revenue from sales. Although REITS are required to distribute 90% of their profits to shareholders, this limits their ability to reinvest and grow. Because REITs are concentrated in real estate, when the real estate market falls or rents drop, REITs can lose value causing their yields to decrease. Non-traded REITs can have additional limitations and risks, including:

  • They can be difficult to value because they aren’t traded on an exchange.
  • They can be difficult to sell.
  • They tend to have high front-end fees, as well as high fees when sold, diminishing returns.

Learn More About How to Use Income Investment Vehicles

All income-generating investments come with risks, and investors who plan to focus primarily on income in retirement should thoroughly understand the specific risks involved. It is important to keep in mind most of these investments aren’t inherently safer than any other investments, but rather expose investors prioritizing income in retirement to different kinds of risk.

At Fisher Investments, we have extensive resources evaluating various types of investment vehicles and can help you learn about the potential benefits and risks associated with each. We can also help review your current investments to determine whether they are properly aligned with your goals. To learn more about our services, contact us today.