Any investment portfolio carries a certain amount of risk based on the assets it contains. An important aspect of retirement planning is balancing that risk against the potential returns of those assets. Assets with high potential and high risk mean you might make a lot of money, but you could also lose it unexpectedly.
On the other hand, choosing assets with low risk and similarly low potential means you’re less likely to lose your investment value, but you’re also less likely to see the level of returns you want for long-term financial success. You can think of asset risk as a continuum, with high-risk assets such as crypto currencies, penny stocks and IPOs at one end, and low-risk choices like bonds, CDs and annuities at the other.
At Asset Preservation Wealth & Tax, we believe a properly balanced portfolio has assets with different levels of risk. How much risk you take depends on your individual circumstances.
Low-Risk is Currently More Attractive
The good news is that low-risk investments are often more lucrative now than they have been in many years, thanks to rising interest rates. As many low-risk investments are tied to interest rates, when rates rise, so do investment returns. There are several low-risk investments that have become more interesting over the course of 2022.
One excellent example of this is U.S. Treasury Bonds. At the beginning of 2022, the 10-year treasury return was 1.63%. As I write this in late December, that return is hovering around 3.5%. That’s an impressive increase, and it means people buying treasury bonds now will earn significantly more money when they mature.
Another investment of interest is CDs. Last year, it was almost pointless to invest in CDs because the interest rate was so low — at one point average 5-year CD rates dropped to 0.26%! Rates like that won’t even keep up with normal inflation, much less the kind of inflation we’re experiencing today.
Right now, however, CD rates are in the 4.5% to 4.75% range. That’s still not the kind of return you can realize with riskier investments, but it’s significantly more attractive than the abysmal rates of past years.
Another investment that’s become more attractive thanks to interest rate increases is annuities. Annuity rates are some of the highest we’ve seen in history. But it’s important to understand that not all annuities are alike.
Fixed-index and multiyear guarantee annuities are essentially loans extended by you. As with any loan, the lender eventually gets the principle returned, plus interest.
On the other hand, variable annuities are tied to the stock market. While this means they tend to make you more money when the market does well, conversely it also means your investment could lose a lot of value if the market takes a dive. That additional risk, frequently combined with more fees than many fixed products, makes variable annuities less of a “safe” investment than fixed annuities
The Right Choice for You
How do you know which products are right for you? The first step when considering“safe” investments is to lower your expectations! Thanks to the exceptional economy of the past decade, people have come to expect a 10-12% return on their investments. That is not a historical norm.
When the dot-com bubble burst in the early 2000s, it took sixteen years for the NASDAQ to return to the levels it saw just before that crash. That’s why it’s important not to expect a 10% rate of return from your investments. Doing so is not supported by historical facts and can have disastrous consequences on your retirement.
For example, if you need $60,000 per year in retirement, and you retire with$600,000, you face a significant risk of running out of retirement savings early! Assuming a more realistic rate of return and saving accordingly is the better approach.
Remember that “lower risk” does not mean “guaranteed-sufficient returns.” There are a number of questions to ask when considering such investments. Ask what kind of time commitment the investment requires, then compare the answer with your needs.
Consider your liquidity needs, as different products will create different liquidity conditions. CD liquidity generally exists only in the interest. You can’t withdraw the principal until the CD matures.
On the other hand, you can take 10% per year withdrawals from annuities. If you will need strong liquidity, an annuity may be a better option for you. Matching your liquidity needs to the liquidity available from the investment will help you avoid unnecessary penalties from early withdrawals.
Learn how interest is credited. Is it guaranteed or indexed? Avoid conflating income with interest. An easy phrase to help is, “Income is what you take; interest is what you make.” Some products essentially return your investment without returning much interest. This tricks some investors into thinking they’re making a good return from the investment when really, they’re just getting their own money back. The problem here is that withdrawing the principle rather than interest erodes the underlying value of the investment.
Finally, consider taxation. Interest rates are rising which means fixed products are getting better by offering higher yields. But those higher yields lead to potentially higher taxes. The product dictates how that taxation is applied.
With CDs, taxes are paid on an annual basis. Bonds, by contrast, have taxes applied as they’re distributed. Annuities give you the greatest tax flexibility, as they are tax-deferred. You can start and stop annuity income as you see fit, which adds tax planning flexibility you wouldn’t otherwise be able to enjoy.
Low-Risk is not No-Risk
While fixed investment products tend to be lower-risk, that doesn’t mean they’re no-risk. Nor does it mean they’re automatically appropriate for everyone. Picking fixed products should be approached with the same care you’d use picking any other investment product. It’s always a good idea to work with a financial professional when choosing where to invest your money
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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