Bonds and annuities are two of the retirement investment options to avoid. Here’s why.
One of the things that investors of all ages fear is that they won’t have a good financial plan in place so that they have enough retirement income to live on once they’ve stopped working. Addressing this concern is usually a high priority for many of our Successful Investor Portfolio Management clients.
Below we list some retirement investment options—both good and bad.
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Retirement investment options: Using bonds will hurt your retirement finances
As some investors near retirement, their advisors recommend switching to bonds and other fixed-income investments instead of holding stocks or stock ETFs.
To some extent, this is an understandable retirement investing strategy, since bonds can provide steady income and a guarantee to repay their principal at maturity.
Unfortunately, using bonds for retirement may not be the best strategy for Successful Investors. Bond prices will likely fall over the next few years because interest rates still have room to rise as central banks continue to combat inflation. Bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down, when interest rates go down, bond prices go up.
We continue to recommend that you invest only a small part of your Successful Investor portfolio—if any—in bonds and fixed-income investments.
Retirement investment options: Is it a good idea to avoid stocks in your retirement?
From time to time, for instance, investors say “Now that I’m retired, I can’t invest in stocks any more. I can’t risk a 30% to 40% drop in the value of my portfolio.”
Some of these investors think that they should switch from stocks into, say, short-term instruments such as T-bills. Sometimes they support this decision with the time-worn one-liner from Ronald Reagan (or was it George Burns?): “I don’t even buy green bananas anymore.”
There are good reasons to stay out of the stock market, but being “too old to have a long term” isn’t one of them.
If you simply can’t accept any instability in the value of your holdings due to temperamental reasons, that is a good reason to sell your stocks, regardless of age. Likewise if you need every dollar you have for fixed financial commitments, such as coming up with a down payment on a home in the next three years or less.
On the other hand, if you have substantially more money than you’ll need for the rest of your life, and you plan to leave the excess to your heirs, it makes sense to invest at least part of your legacy on their behalf. That is, invest based on their time horizon, not yours.
For instance, if your heirs are in their 40s, you should hold at least part of your portfolio in a selection of investments that would suit investors in their 40s. Of course, you’d still want to invest conservatively. But you’d want to take advantage of the many years that 40-somethings have till they reach retirement age.
If you hold your money in T-bills for the last few years of your life, it will generate a minimal return after taxes—you may actually lose money after accounting for taxes and inflation. After your death, it may take months or longer to settle your estate. After that, your 40-something heirs may need time to put your legacy to work, especially if they are inexperienced as investors. They may have passed 50 by the time they get around to investing in an age-appropriate fashion. Missing out on, say, three years of even moderate returns can take a big bite out of the funds they’ll have a few decades later, in retirement.
Retirement investment options: Be wary of annuities
Stable, predictable income is a plus for any retirement plan. However, annuities do have disadvantages that can lower your overall retirement investing income.
It may be hard to get out if you change your mind: Unlike stocks, it can be difficult or impossible to sell an annuity if you decide it no longer meets your needs. Moreover, you will likely get a low price for your annuity because the date of your death is uncertain.
Link to interest rates makes today a poor time to buy annuities: The rate of return you receive on an annuity is linked to interest rates at the time you buy it. That makes periods of still relatively-low interest rates, like today, an especially poor time for buying annuities. However, if you want to buy annuities, you could buy one annuity a year for the next five years. That way, your returns will increase if interest rates rise, as we expect.
Tax treatment: When you own an annuity, the income payments you receive are made up of interest and a return of your principal. The return of your principal is tax free, but the interest portion of the payment is taxed as ordinary income.
Ordinary income is taxed at a higher rate than returns on a stock portfolio. If you build your retirement investing portfolio as we recommend, part of your return would come in the form of dividends from Canadian stocks, which qualify for the dividend tax credit. The remainder would come in the form of capital gains, which are taxed at roughly half the rate of ordinary income, and are only taxed in the year you sell.
What types of investments will you focus on the most in your retirement planning?
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