Investing For Retirement

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Category: Investments

The next most important rule in achieving high retirement savings is to use a sound strategy. A sound strategy does not necessarily mean the safest strategy. Rather, a sound strategy is one which goes further, taking on a moderate amount of risk, in order to boost the average annual return over time. Consider someone starting with $100,000. After 30 years, the value of the portfolio, compounded at 5%, would be $444,671. If, instead, the portfolio compounded at 8%, the value would be $1,052,470. This is an enormous difference and would probably mean a lot to a retired person's comfort level and enjoyment of life. This illustrates why it is important to work hard to produce the extra 2 or 3 percentage points of average annual return.

Certainly, there is a higher risk associated with owning stocks, and the returns cited are for the broad stock market as a whole (not individual company stocks which may have done better or worse). In addition, there is greater volatility of returns year by year for stocks compared to the others, although over 10 year periods since the 1950s, stocks have shown positive returns. Will history repeat itself? That is, will a properly diversified stock portfolio continue to outperform T-bills and bonds? There are no guarantees. However, with history on their side, investors with at least 5 to 10 years until retirement should consider some stock ownership in their portfolios. Perhaps, with portfolio half in stocks and half in bonds, they would be able to achieve something closer to 8% on average than 5% over a period of a decade or more.

Bond interest is taxed fully as income. For investments outside of tax-sheltered retirement plans, investors can often achieve greater after-tax income, with a minor amount of extra risk, by owning preferred shares of large established companies. The dividend interest is taxed at an approximate 35% rate for top income earners, compared to around 50% for interest income. This can mean a considerable tax saving at all income levels. People owning bonds are often at a disadvantage due to inflation. The amount of interest from bonds may be sufficient for current expenses, but will it be enough in 10 or 15 years when expenses are higher? A sound strategy, then, for people who are just retired and are facing another 20 or more years of life expectancy, would be to have at least some portion of their investments in assets that keep up to inflation. For some, the ownership of their home or other real estate may be enough. For others, it may be wise to have some ownership of stocks, in order to achieve the higher returns over time.

For retired people invested in stocks via mutual funds, a systematic withdrawal plan could work well as an alternative to owning bonds. Such a plan would allow the withdrawal of funds on a monthly or annual basis, much like receiving interest from a bond. However, there are two important benefits: (1) the amount withdrawn in the early years would be treated for the most part as return of capital, and therefore not taxed; and (2) if the rate of withdrawal is less than the rate of return achieved by the mutual fund, then the amount invested would continue to grow over time. Instead of, or in addition to, investing in bonds, using a systematic withdrawal plan connected to an equity mutual fund could well allow a retired person a higher after-tax income as well as inflation protection. (Direct ownership of a properly diversified stock portfolio could achieve the same advantages).