Transitioning from employment paycheck to retirement income takes quite a bit of planning to ensure you start off on the right path. When creating your retirement income, finding the right investment balance to your portfolio can be tricky. If you put too much in an aggressive portfolio, you run the risk of taking a loss when there is market volatility. But a too conservative portfolio might not bring you the returns you need to maintain your desired income.
Before you can come up with a retirement income plan, you need to understand the risks that are not necessarily involved with the return, but the risk that is built into the type of investment. For example, risk is not defined purely from market or investment performance, but how long your investment is tied up and whether you will be able to access the funds when needed without taking a penalty.
When creating your retirement income, you will probably look at a wide range of different types of investments that are available but might not always understand the type of risk associated with each one. Investor.gov, an SEC website, came up with some definitions of the most common risks investors face, which include:
With a stock, you are purchasing a piece of ownership in a company. With a bond, you are loaning money to a company. Returns from both of these investments require that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. If there are assets, the company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.
If you are purchasing an annuity, make sure you consider the financial strength of the insurance company issuing the annuity. You want to be sure that the company will still be around, and financially sound, during your payout phase.
Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.
Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.
Interest Rate Risk
Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).
But what does this mean for my retirement income?
Before you start investing in any type of products, know what type of risk is involved when making your decision. In the financial industry, it is not uncommon to have to explain to a client that if they wish to withdrawal their CD early there will be a penalty. That just indicates one of three things, the client didn’t understand the tradeoff of earning a higher interest rate by locking up the money for longer, the banker did not give a thorough enough explanation, or the client did not really understand their own financial needs. In almost every case, it is the last one. They tied up too much money in a product that they can’t access for a specific timeframe. We spend weeks researching and planning for a vacation, but very little time invested in making ourselves a financial plan. Before you finalize the decision to retire, this should be your top priority.
Take a minute and think about how you have budgeted your whole life. Your paycheck was broken down into different categories for different needs, whether it be for immediate bills, college savings accounts, or long-term investing. Retirement income is exactly the same, but instead of breaking down your paycheck, you will need to take your savings and break it down into categories for your retirement needs.
Your retirement income is normally separated into ‘baskets’, ‘buckets’, or ‘bundles’ of money you will use to live the next 10, 20, 30+ years on. I always use buckets because it’s easy to visualize. When one bucket gets low, the other pours into it and replenishes it. Each bucket represents a timeframe during your retirement, going from immediate needs to long-term. Make sure you have a set plan for each of your buckets, so you know you will stay financially stable throughout your retirement.