Planning Your Rest-of-Life: Diversify Your Retirement Income

By now, you're most likely familiar with the concept of diversifying your investments, where you allocate your money among different types of assets, and then invest in a number of securities within each asset type. This spreads out your risk and minimizes your vulnerability to the poor performance of a specific security or an entire asset class.

Here's an important refinement to this idea for your retirement years: Diversify your retirement income, too. Because you never know what the future will hold, you want to have different sources of income that can withstand various types of economic challenges. This will help you develop a reliable income stream in your retirement years, no matter what comes along.

Let's take a look at ...

How Various Retirement Income Sources Fare in Different Economic Climates

Income             "Normal"   Recession/       High
Source             Times*      Deflation         Inflation

Social Security:      Good            Best             Good
Pension/Annuity:    Good            Best           Poor
Stocks:                   Best              Poor            Mixed
Bonds:                    Good            Good           Poor
Cash**:                 Poor           Best             Good
Real Estate:           Good        Poor             Best
Hard Assets***:    Mixed           Poor             Best
Wages:                 Good            Mixed        Good

*     Low inflation, steady economic growth
** T-bills, money market funds, FDIC-insured savings accounts
*** Gold, silver, commodities, collectibles

I realize this is a complicated chart, and there's no need to memorize it. Let me just make some general observations.

A Closer Look

Note that the only source of income that does well in all three economic scenarios is Social Security benefits. This is one reason why maximizing your Social Security income by delaying the start date is a good strategy for most people.

You'll see also that wages have the potential to do well in all three economic scenarios, so keeping your feet in the job market is a good strategy. The "mixed" rating for wages in a recession reflects the fact that it can be challenging to find work during a recession. If you can get a job, however, then wages rate as "good." But it's a risk to rely heavily on wage income if you're employed in a job that's vulnerable to layoffs.

Every other source of income does well in some climates and poorly in others. Since it's very hard to predict when these economic climates will occur during your retirement years, a sound strategy is to diversify your sources of income so you're not vulnerable to a particular type of economic downturn.

With stocks, bonds and cash, the ratings work whether you're living on just the income you get from these investments or are withdrawing principal. If you're just living on the income, however, you're less vulnerable to economic downturns compared to withdrawing principal. Why? The income from a diversified portfolio of these types of investments fluctuates much less than the underlying value of these investments, and you won't be forced to sell your investments when asset values are low.

For the above ratings, the only type of real estate I considered was investment real estate--individual properties or real estate investment trusts (REITs). Since real estate can be difficult to sell, it's a good idea to live on just the income from these investments. Don't put yourself in the position of needing to sell real estate when times are bad.

I usually don't count your home as a retirement investment because it's most likely you won't be selling it to raise money. Instead, I consider it a way to manage your living expenses, which is a different--but important--goal. Of course, you can sell your home to realize a profit, but recent declines in real estate values have illustrated the risk of this strategy.

Most of the time, your own home won't generate income during your retirement years to cover your ordinary living expenses. The one possible exception--and it's a good one for some people--is to rent out a room or two to a boarder while you're still living there. Yes, you could get a reverse mortgage or home equity loan, but I think it's a mistake to use these to pay for ordinary living expenses while you could still work. Instead, I suggest that you hold reverse mortgages and home equity loans in reserve until you desperately need the money, for instance, to pay for long-term care expenses.

I'm not a fan of hard assets as described in the chart above, since most of these don't produce income. If you need money to pay for living expenses, you need to figure when to buy low and when to sell high. This can be a tough goal, even for professional investors.

Another Type of Diversification

Here's yet another important way to diversify your retirement income: Make sure you have significant income that's payable for your life, no matter how long you live. Social Security, pensions and life annuities are all guaranteed for life; if you're married, these sources can also provide income to your spouse if he or she outlives you.

Some employer-sponsored pension plans offer a lump sum in lieu of a lifetime income. If you take the lump sum, understand that you're reducing your diversification. If you're offered this choice, please consider your decision carefully; this is one of the most important financial decisions you'll make regarding your retirement income. (See the Resource Center in my website www.restoflife.com for an article that discusses the pros and cons of this option.)

Most other sources of retirement income--stocks, bonds, cash and real estate--have the potential to run out while you're still alive. However, this risk is minimized if you rely on just the investment income from these sources. If you're withdrawing principal, then you'll risk outliving these assets, so it's even more important to have significant sources of lifetime income.

The October 2008 issue of my "Planning Your Rest-of-Life" newsletter described the challenge of inadequate retirement resources for many baby boomers, with the inevitable conclusion that many people will need to work in their retirement years. But because wages aren't usually a source of lifetime income (since there can come a time late in life when you're not able to work), it's important to build financial resources that can generate retirement income. And remember, it's never too late to start saving!

Some Final Thoughts

There are many ways to implement the ideas in this issue of the newsletter. For instance, I like immediate annuities as a "do it yourself" source of lifetime income, but you need to be careful in selecting annuities in order to avoid high fees and poor performance. It's also important to keep things simple. There can come a time when you're less able to manage your investments, so you need to make sure you don't place too much emphasis on complicated, high-maintenance investments.

I've covered these and other considerations in previous newsletters--visit the newsletter archives in the Resource Center on my website www.restoflife.com to read past issues. And I'll continue to discuss these issues in the future.

My grandfather, who was a stockbroker during the Great Depression, often repeated this good advice: "Don't put all your eggs in one basket." He meant the classic version of diversification--spreading investments across different asset classes and using more than a few securities.

I'm advocating that we take his advice a step further to create reliable sources of income that will continue through thick or thin. It takes some time and effort, but it's worth the peace of mind knowing that we can survive whatever happens in the economy. This lets us focus on what's really important--reaching our full potential during our retirement years, taking care of unfinished business, spending time with friends and family, and passing along our legacy.

PS. Visit our newly revised and upgraded website www.restoflife.com. It features a video library, an archive of this highly regarded email newsletter, articles, worksheets and lists of recommended resources, all that help you live long and prosper! Your time will be well-spent.