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August 25, 2018

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The Need to Diversify Your Retirement Income Sources

May 6, 2017

For people who are handling their own investments there is one guideline that should never be ignored. That guideline is to diversify your investments. This will reduce the risk of your portfolio taking a large hit if one investment underperforms relative to others. Even in boom times when some investments seem to be sure things people should still diversify their investments. As the saying goes, don’t put all your eggs in the same basket. Most people thought there was no such thing as a bad real estate investment in the years leading up to the housing crash in 2007 yet we all know how that turned out. And anyone who was invested with Bernie Madoff believed they were fortunate as they were told they were earning a steady 12% return annually, until they weren’t. The examples are nearly endless, but people have short memories and tend to forget the past when the next big thing comes into play. The important thing to remember though is that no matter how good an investment seems like it is, odds are that it can turn sour in a hurry. Because of this reason people must diversify their investments or else they run the risk of losing a large amount of their capital unnecessarily.

 

Diversification is important in not just selecting investments, but also in developing sources of income for their retirement. Traditionally in America the main sources of retirement income came from an employers’s pension plan, income from assets, and social security. Unfortunately, times have changed and companies are now shifting the risk from employer to employee. They are doing this by not making any promises into the future that they will pay out funds. Instead they are now giving employees a small percentage of their paycheck which can be used to fund their 401(k) account. An employee can also put in a certain amount to help fund their retirement. Because of this shift in retirement plans being offered the responsibility of owning your own retirement is now in each individual’s hands, rather than in their employers. There are now many ways in which a person can have income generated during retirement. These sources include, but are not limited to, social security, pension plans, 401(k) plans, Roth IRA accounts, traditional savings, dividends and interest, rental income, royalties, part-time work, and the sale of assets.

 

Much like there is not one perfect investment there also is not one perfect source of retirement income. Years ago people probably thought social security was the bees knees and thought it could never go away. Well it’s true it probably won’t disappear completely, the benefits paid out will most likely be greatly reduced over the next 30 years. This is because there is a large funding gap and politicians tend to stay away from the issue, passing the buck onto the next politician. Other people probably thought that a pension plan was the way to go and that it was a sure thing, unfortunately we probably all know someone who gave many years of service to a company, only to see their pension plan either completely revoked or greatly reduced due to pension fund managers assuming a greater rate of return over time than could reasonably be expected. Nowadays you’ll hear people talk of the 401(k) as a must. Although I agree that it’s a great tool to help someone achieve their retirement goals, I don’t think it should used as the only instrument for one’s retirement. Who’s to say that taxes won’t increase prior to retirement or that the government won’t raid accounts to help pay the growing deficit? Both of these aren’t likely to happen, but by diversifying you’re removing the need to rely on one source for all of your retirement needs. Take a look at the chart below, developed using data from the social security administration, to see how people age 65 and older are earning their income.

 

 

 

From the chart above you should notice that these days less people are reliant on pensions and social security while more people rely on income from their assets (dividends, interest, rental income) and are working part-time.

Generally speaking, when it comes to retirement income, the more the better. Most likely you’ll never hear people say they have too much money in retirement, oftentimes it’s the opposite, they have too little.  When thinking about your sources of retirement income it’s important to consider taxes. Think about the 401(k) account versus the Roth IRA. Both accounts are great in that they’ll allow investments to grow tax-free, but the accounts are still very different. The Roth IRA is funded with money that has already been taxed. This means that when you do retire and start pulling your money out of this account you will no longer be taxed on it. On the other hand the 401(k) account is basically the opposite. Money used to fund the account is pre-tax, however, once you go to withdraw money from the account it will then be taxed at the current rates. If you are only funding your Roth IRA you are hoping that your current tax rate is either lower or equal to your retirement income tax rate. With the 401(k) you are hoping that your current tax rate is higher than your retirement income tax rate. Even if tax rates stay the exact same between now and when you retire it’s still difficult to know how much you’ll be withdrawing each year. Because of this it’s important to diversify your income sources. By funding both your Roth IRA and your 401(k) account you’ll be able to pick and choose where the money comes from, effectively lowering your taxes owed in the future. I know many people who are maxing out one account but neglecting the other account completely. In a way they are gambling with potential tax losses of tens of thousands of dollars if tax rates were to move against them in the future. Again, most of this risk could simply be diversified away.

 

So what is my plan for retirement income? I’m currently hoping to generate income from six separate sources. Those sources include my 401(k), Roth IRA, social security, dividends on investments, part-time work, and income from a rental property. By simply working and paying taxes each year I’m building up my social security base, which in turn should generate an increasing amount of social security income. By contributing small amounts monthly into both a 401(k) and a Roth IRA I am knocking another two sources out of the way (and also giving myself options for tax reductions come retirement). Opening up DRIP accounts and automating savings monthly I am hoping to keep the dividends earned growing over the next decade or two, upon which the dividends earned should be a healthy amount. That just leaves part-time work, which I’ll worry about come retirement, and rental income. What happens if I only get income from four of the six? Most likely I’ll still enjoy a fruitful retirement as I didn’t count on one source to generate all of my income. What were to happen though if I was only counting on one or two sources of income and then due to some unforeseen event I lost one of those sources? The consequences would be disastrous and one that I hope people don’t have to realize.

 

How about you? Do you think there is a need to diversify your retirement income or do you feel that one or two sources is adequate?

 

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