As investors approach retirement, they need to look at their investing strategy in light of their retirement income needs. This is often a time when many investors transition their investment portfolios to lower risk investments that will generate the level of passive income they need in the coming years.
Relook at traditional income strategies
Traditionally those in or approaching retirement would have looked at passive income investments like bonds, CDs, dividend paying stocks and other similar types of investments. In today’s environment these types of traditional income generating options may not throw off enough income for retirees.
- Interest rates have dropped, and bond yields have fallen as well.
- A number of traditional dividend paying stocks have cut or postponed payments due to the pandemic
- The current inflationary environment is less than ideal for yield-focused investors, especially retirees. With the acceleration of business activity and the rise in prices for food and a number of other consumer staples, the prospects for increased inflation are present. Inflation is the enemy of fixed income investors and of retirees who may be on a fixed or semi-fixed income.
Deborah Stokes, Financial Advisor with Wedbush Securities in La Jolla, CA says, “With bond yields stubbornly low, looking beyond traditional income strategies can be advantageous for investors, especially retirees living on fixed incomes. For investors holding individual bonds which may have appreciated in value as rates have fallen, opportunities exist. One strategy would be for appreciated bonds to be sold and proceeds reinvested into income focused closed-end funds.”
She adds, “This strategy can provide investors an opportunity to lock in gains and increase income by investing in a diversified portfolio of income producing securities that may have the added benefit of inflation protection.”
Alternative income strategies to consider in today’s environment
There are a number of alternative income strategies that investors seeking yield can explore. Income-focused closed-end funds as suggested by Ms. Stokes are one such strategy that falls under the pass-through securities umbrella.
Stokes says, “Pass-through securities, such as closed-end funds, can offer retirees a good source of increased income and portfolio diversification in this low interest rate environment. Asset managers have risen to the occasion, creating new funds that hold a variety of income producing investments from dividend paying stocks, bonds and floating rate loans to fixed-income portfolios, or a combination of each. Investors can choose from funds constructed of diversified portfolios with a focus on maximizing current income, many that pay monthly, providing investors the added benefit of a more level income stream.”
Four types of pass-through securities investors might consider:
- Real Estate Investment Trusts or REITS offer a tax-efficient way to invest in real estate without having to actually purchase properties. REITS invest in various types of income producing properties or mortgages. By rule, REITS are required to pass-through a portion of the income produced by their investments to the shareholders.
- Closed-end funds are pools of investments such as stocks or bonds and are often brought to market via an IPO process. CEFs are traded on the stock exchange like an ETF, but they have many of the characteristics of mutual funds. CEFs generally offer higher yields than open-end mutual funds.
- Business development companies (BDCs) are publicly traded entities that help small to medium-sized businesses grow through investments in them or via lending to these companies. In order to attain BDC status, the entity must invest at least 70% of its assets in companies with less than $250 million in market capitalization.
- Master limited partnerships or MLPs are funds with a hybrid structure that combine aspects of a partnership and a corporation. Many MLPs focus on the oil and gas industry and invest in companies engaged in pipelines, distribution and refining activities. The distributions from MLPs offer a degree of tax shelter for investors.
Many pass-through securities offer consistent and tax-efficient income that can be beneficial to retirees in today’s challenging income investing climate.
A note of caution from Edward Zubow, Investment Advisor with Wedbush Securities in Scottsdale, Arizona, “With regard to closed end funds, I think it is important to warn people that CEF’s may offer higher and more attractive yields, but they may also come with significant hidden risks. CEF’s don’t adhere to the same rules as traditional mutual funds. As such, they can, and oftentimes do, utilize as much as 30% leverage in the portfolio to generate the attractive yields that some higher yielding CEF’s offer. Investors who utilize CEF’s need to understand that, because of the use of leverage, they should expect, and be able to tolerate, much greater and disproportionate volatility if and when markets move against them.”
This is a good point and income seeking investors should understand the pros and cons of any type of income generating investment they are considering. Your Wedbush Financial Advisor can help you choose the right investments for your portfolio based on your goals and risk tolerance.
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Disclosure
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.