The Challenge of Investment Income

One of the hardest aspects of an investment portfolio to get right is planning for income.  Many people (including me at times) are mistaken in thinking that the total balance should be the sole focus of investment and retirement planning.  For retirement, trying to plan a sufficient stream of income is one of the most challenging things. Recently, there’s a lot of talk about annuities as a vehicle to help with future income planning.  Below are the pluses and minuses that I’ve seen (and experienced) with different income products.  Since I’m still exploring, I’m open to suggestions from others.

CDs, CD ladders — these investments have the benefit of relative predictability of income, FDIC insurance up to a certain threshhold, and (unless your bank defaults) no real loss of principal. The main problem is that CD rates are currently abysmally low, there is rollover risk (rates come down on the day you want to rollover), and CD rates generally don’t keep up with income.

Regular bonds and bond funds — bonds are not FDIC insured, but generally pay higher rates. Known as fixed income investments, the coupon levels are usually fixed.  The main risk with these are that a rise in interest rates means the resale value of your bonds go down and hgih yield bonds do carry some default risk.  Unfortunately, bonds are at risk of underperforming against inflation.  Fortunately, bonds have outperformed stocks in the last few decades.

Annuities — annuities are instruments issued by insurance companies that can have either a fixed payment or a variable one that depends on investment performance typically for the life of the holder. The benefit of a fixed annuity is the predictability of income.  The downsides are generally high management fees, credit risk of insurance company, and guaratees are limited by each state’s insurance fund.  Although annuities can designate another beneficiary such as a spouse, the principal value cannot be recoverd.

Managed Payout Funds -- these are relatively recent concoctions from various mutual fund companies and involve a mixed portfolio of stocks, bonds, and other investments (including derivatives) that aim to have a certain percentage payout.  Unlike annuities, managed payout funds can be sold should you need a large amount of cash for an emergency or wish to switch investments down the road.  Also unlike annuities, these funds have a desired target payout but make no guarantees, with the downturn in the market in 2008, most payout funds have reduced their monthly payouts in the past 2 years.

Do-it-yourself investments -- this is the path that most people take, by not opting for one of the above, and instead trying to cobble a hodgepodge of investments where dividends, interest payments, and sales cover enough income.  Unfortunately, this strategy usually looks good in an up market and terrible in a down market.

I think this means that I have a lot more research to do.

shared at this week’s Carnival of Personal Finance