Investment experts often talk about the importance of diversification, the strategy of incorporating a broad variety of assets and asset types in your portfolio. Diversification helps to reduce risk by balancing the potential for losses with the guarantee of income. You’re securing multiple sources of retirement income, some that are risky and others that are less so.
Income sources like Social Security and pensions can certainly help you secure the future you want, but they aren’t the only ways. To help you achieve a well-diversified portfolio, we provide brief overviews of four sources of retirement income.
A stock is an investment vehicle that gives the stockholder partial ownership, called a share, in a publicly traded company. The more of a particular stock you own, the more shares you have. Companies sell stock to raise capital, maybe to pay off their debts or fund new projects. Some stocks provide dividends, which are portions of a company’s profits distributed to shareholders.
The primary advantage that stocks offer is their long-term growth potential. A stock that performs well on the market can increase exponentially in value, netting the stockholder a hefty profit when they sell it. On the other hand, stocks also carry significant risk because no one can predict the movements of the market or the performance of any stock on it, meaning that you can also lose money.
A bond is essentially a loan that an investor provides to the issuer — typically a government or corporation — in exchange for which the issuer promises to pay back the loan, as well as accrued interest, upon maturity. Many investors buy bonds in a laddering strategy, by which they purchase bonds that mature at different dates, which can minimize the risk of interest rate fluctuations.
The upsides of bonds are that they’re relatively safe, as the issuer is obligated to pay you back, and they provide predictable returns. They do present some risks; however, particularly the risk of the issuer defaulting and the risk of their value falling in light of rising interest rates.
A retirement account, also known as a retirement plan, is a savings vehicle into which you make regular contributions that accrue interest. Two of the best-known types of retirement accounts are 401(k)s and individual retirement accounts (IRAs).
There are two types of 401(k)s: traditional and Roth. Both are employer-sponsored plans by which an employee chooses investment options whose performance determines the growth of the account’s value; the only difference between them being that Roth plans are funded with after-tax dollars.
IRAs are similar to 401(k)s except they aren’t always employer-sponsored and they tend to offer a broader variety of investment options. There is also more variety in the types of IRAs you can open:
- Traditional IRAs are funded with pretax dollars, and contributions are usually tax-deductible.
- Roth IRAs are funded with after-tax dollars, and the contributions are not tax-deductible.
- SEP IRAs are employer-sponsored.
- SIMPLE IRAs are employer-sponsored plans specifically provided by small businesses.
One of the biggest general advantages of retirement accounts is that they help to automate interest-accruing savings. However, retirement accounts also have contribution limits, which cap the growth potential of a given account. Typically, there are also penalties for withdrawing from your account before the age of 59.5.
When you’re investing for retirement, you want to be sure that you have guaranteed income set up to fund your preferred standard of living. An annuity can help you achieve that.
An annuity is an insurance contract that you can fund with a lump sum or a series of payments. Your contribution grows tax-deferred through an investment portfolio devised by the insurer. Interest gets credited to your account in accordance with an insurer-determined rate or market performance. At the end of the contract, you can opt to convert it into a steady stream of payments that last either for the rest of your life or a specified period thereof.
There are multiple types of annuities, primarily:
- Fixed: A fixed annuity offers a set rate of return for the life of the contract.
- Variable: With a variable annuity, the rate of return fluctuates depending on the performance of an underlying investment portfolio.
- Indexed: An indexed annuity is similar to a variable annuity except that it’s tied to an underlying market index, such as the S&P 500.
The different annuities offer different advantages. Fixed annuities offer a guaranteed and predictable return, variable and indexed annuities have high growth potential, and indexed annuities offer principal protection. The disadvantages may vary as well. Fixed annuities tend to have lower growth potential, variable annuities can result in losses, and indexed annuities may have limits on how much you earn.
A well-diversified portfolio may include any or all of the above, and more. To better understand diversification, additional assets to include in your portfolio, and potential strategies for maximizing your returns, discuss your options with a financial adviser.