What Are The Best Investments For Retirement?
- By Kyle Rolek, Fiduciary Financial Advisor and Certified Financial Planner
What are the best investments for retirement? While there is no single best investment, the best investment approach for retirement is to create a well-organized investment plan. This article walks through an example retirement investment plan.
Retirement Investment Plan Step #1: Create a Retirement Cash Flow Statement
The retirement cash flow statement compares your retirement expenses with your retirement income from non-investment sources such as social security and pension plans. An example retirement cash flow statement is shown below. This family is projected to have about $84k of expenses during their first year of retirement in 2021. They are projected to have about $64k of income from social security and pension plans after taxes are taken out. As a result, they are projected to have a “retirement income shortfall” of about $20k in 2021. This means their retirement investment plan will need to produce about $20k per year, after taxes, in 2021.
Retirement Investment Plan Step #2: Build the Allocation
To organize your retirement investment plan, financial accounts and investments can be grouped into three categories.
“Short-term Bucket” – This bucket primarily includes FDIC insured bank accounts such as most checking accounts and savings accounts, short-term CDs, and money market funds. The purpose of this bucket is principal protection and easy access to money to pay expenses.
“Middle Bucket” – This bucket primarily includes high-quality bonds, such as US Government Treasuries, and bond funds that invest in high-quality bonds. Long-term CDs may also be included in this bucket, although in the current interest rate environment as of 2020, long-term CDs are unattractive. The purpose of this bucket is principal protection and slightly higher interest compared to the “short-term bucket”.
“Long-term Bucket” – This bucket primarily includes high-quality stock investments which, as of 2020, may include companies like Apple, Microsoft, Amazon, Google, Visa, etc., and/or stock funds that own many high-quality companies. The purpose of this bucket is long-term growth to beat inflation.
In this example, the family has $1m in total between all bank accounts, IRA accounts, 401k accounts, and non-retirement investment accounts. We’ll discuss how much this specific family put into each of the three buckets below.
It’s important to discuss your own unique situation with a fiduciary financial advisor who has retirement planning expertise to setup a retirement investment plan that’s customized for you. This is not stated as a generic disclosure. Really, it’s important that you understand your own unique retirement investment plan and that you stick with it for the long-term. If you do not understand your retirement investment plan (or if you don’t have a retirement investment plan at all), results will likely suffer. The example that follows was built in close collaboration between the family and their fiduciary advisor who specializes in retirement planning.
In the “short-term bucket” – They decided to allocate $50k to the short-term bucket. In this example, this amount represents over 2 years of their retirement income shortfall. This leaves them a sizeable cushion to pay monthly expenses, and also leaves them a healthy reserve for emergencies that will pop-up from time to time.
In the “middle bucket” – They decided to allocate $200k to the middle bucket. In this example, this represents 10 years of their initial retirement income shortfall. This protects them for a fairly long time from needing to sell investments in their “long-term bucket” when the market is down.
In the “long-term bucket” – They decided to allocate $750k to the long-term bucket. This bucket is very likely to decrease in value at times when the market is down. It will absolutely experience down months, quarters, years, and potentially consecutive down years from time to time. However, if it’s invested well and if they stick with their plan, it’s also likely to produce the long-term growth they need to beat inflation over the course of their retirement. At a hypothetical 7% rate of return, $750k in the long-term bucket would double to $1.5m in 10 years.
At times when the market is up, growth in the long-term bucket can be redistributed to re-fill and/or grow the short-term bucket and middle bucket.
At times when the market is down, having 2+ years of their retirement income shortfall in the short-term bucket and about 10 years of their retirement income shortfall in the middle bucket will buy time for their long-term bucket to eventually recover and continue onto new highs.
Retirement Investment Plan Step #3: Setup Income Distributions
In this example, the family needs $20k per year, after taxes, to fill their retirement income shortfall. They will take monthly distributions from a Traditional IRA account in the husband’s name, who is older, to fill their shortfall.
Because the money is coming from a Traditional IRA account, they’ll have to pay income taxes at the federal level. Some states also tax IRA distributions at the state level. Pennsylvania does not tax IRA distributions at the state level.
Based on this family’s income, they’ll likely fall in the 12% tax bracket when the standard deduction is factored in (based on 2020 tax rates shown below).
The $20k annual retirement income shortfall is $1,667 on a per month basis. To get $1,667 per month after taxes, the family can setup gross monthly distributions of $1,895 per month and have taxes withheld at 12% federal rate. Because they are located in Pennsylvania, they do not elect to have state taxes withheld because the IRA distribution will not be subject to Pennsylvania tax.
Retirement Investment Plan Step #4: Re-evaluate Regularly
Here are six reasons to re-evaluate your retirement investment plan and overall retirement plan regularly. This is not a comprehensive list:
1 – Your expenses will likely change over time. For example, inflation is likely to increase expenses over time. On the other hand, travel may decline later on in retirement which may reduce expenses.
2 – Your income may change. For example, you may take a part-time job and need less income from your investments then initially expected. On the other hand, if your plan initially included part-time income and you later stop working entirely, then the amount of income you’ll need from your investment will likely increase (unless you reduce expenses too).
3 – The Social Security program may change. Minor annual cost of living adjustments probably won’t require any updates to your retirement planning. However, significant changes to how benefits are taxed, or the establishment of means-testing criteria could impact your retirement income significantly, and a change to the retirement investment plan will likely be needed in response.
4 – Tax rates may change. Minor changes to the tax brackets may not make enough of a difference to make updates to your retirement plan necessary or beneficial, but significant overhauls to the tax code could require an adjustment to your overall retirement plan.
5 – Death of one spouse. Updates needed when one spouse dies may include switching to the social security survivor’s benefit, adjusting for lost pension income, adjusting for potentially lower expenses, and updating the estate plan.
6 – Changes in the investment environment. Changing your investment plan because the market dropped, or changing your investment plan based on predictions about where the market is headed next will likely cost you money over the long-term. However, there are legitimate reasons to consider updating your investment plan. For example, if interest rates increase significantly at some point in the future and bonds, or even CDs, become more attractive as a result, it could make sense to at least re-evaluate your current split between stocks and bonds.
What are the best investments for retirement? Again, there is no single best investment. The best investment approach for retirement is to create a well-organized retirement investment plan. A fiduciary financial advisor with a retirement planning specialty is well-equipped to help you establish an investment plan for your retirement.
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