3 Ways to Hedge Your Bets to Have a Secure Retirement
Bad things can happen, so here is how to protect yourself
(The following article originally appeared on RealDealRetirement.com.)
I’m not a big fan of hedge funds. Too complicated, too expensive, too opaque. But I am a big believer in hedging your financial bets so that you can still succeed even if the future doesn’t unfold exactly as you expect.
Toward that end, here are three crucial hedges you should include in your retirement planning to boost your chances of achieving a secure post-career life:
1. Hedge your asset exposure. I’m not talking about rocket-science strategies that involve mixing and matching every arcane asset class you can lay your hands on — rare earth ETFs, volatility futures, wind energy stocks, etc.
Rather, your aim should be to make sure you’ve got the basics covered — large stocks and small representing all industry sectors, a broad spectrum of high-quality bonds in varying maturities — while not relying too heavily on any one asset class, industry or sector.
Even more important, you want to be sure that the ratio of stocks to bonds in your portfolio represents your true tolerance for risk (which you can gauge by completing this risk tolerance-investor questionnaire.)
Fortunately, creating a portfolio that gives all the asset classes you need is pretty simple. You can build a fully diversified portfolio of domestic and foreign stocks plus U.S. bonds with just three funds or ETFs — a total U.S. stock market fund, a total international stock funds and a total international stock fund. You can gain exposure to other asset classes if you wish by adding funds or ETFs that invest in, say, international bonds, high-yield bonds, real estate (REITs), commodities and precious metals, etc.
But don’t overdo it. The more investments you add to your retirement porfolio, the more likely you’ll be “di-worse-ifying” it rather than diversifying it, and you may end up with an unwieldy mess that’s hard to manage and could even implode on you.
2. Hedge your tax exposure. In theory, you’re better off saving for retirement in tax-deferred accounts like traditional 401(k)s and IRAs if you expect to drop into a lower tax bracket in retirement. The reason: you avoid a tax bill at a high tax rate during your career and instead pay taxes at a lower rate when you withdraw your contributions and earnings after retiring.
The opposite is true for Roth 401(k)s and Roth IRAs, so they’re generally a better idea if you think you’ll face a higher tax rate in retirement.
But things are more complicated in real life.
Predicting the tax rate you’ll pay in the future can be a dicey business.
And Roth accounts have other advantages. Unlike with traditional IRAs, you don’t have to begin making minimum withdrawals from a Roth IRA when you reach age 70 1/2 (although in his 2016 budget, President Obama did propose, without success, subjecting Roths to the same withdrawal criteria as traditional accounts). And Roth withdrawals are excluded from the calculation that determines whether any of your Social Security benefits are taxable.
Which is why it’s a good idea to hedge by having at least some savings in both traditional and Roth accounts. And to the extent you invest for retirement in taxable account, you should consider including investments like index funds and ETFs and tax-managed funds that generate much of their return through unrealized capital gains that qualify for long-term capital gains rates, which are typically lower than the ordinary income rates that apply to taxable withdrawals from tax-deferred accounts.
Diversifying this way allows you to avoid having the after-tax value of all your retirement savings dependent on a single tax rate. You also have more flexibility in managing your tax bill in retirement. For example, if withdrawals from tax-deferred accounts are getting close to pushing you into a higher tax bracket in a given year, you can tap a Roth account for tax-free income or sell appreciated assets in taxable accounts for a gain that will be taxed at the lower long-term capital gains rate.
3. Hedge your sources of retirement income. Most retirees these days have two main ways of replacing their paycheck in retirement: Social Security and draws from their savings. (If you’re fortunate enough to be in the minority of people who also receive a traditional check-a-month pension, then you have three.)
But there are number of ways you can hedge your bets so you effectively increase the amount of income you get from those sources and even increase the number you can draw on.
Take Social Security. By postponing when you start collecting benefits — or, in the case of married couples, employing one or more “claiming strategies” — you may be able to boost your lifetime Social Security benefit by tens, if not hundreds, of thousands of dollars.
And if you decide that you would like more guaranteed lifetime income than Social Security alone will provide, you can always consider converting a portion of your nest egg to an immediate annuity in return for lifetime monthly payments. (This annuity calculator can show you how much you might receive given your age, sex and the amount you invest.)
But there’s even more you can do to better assure you’ll have the income you need to live the retirement lifestyle you want.
If you have equity in your home, for example, you might consider tapping it with a reverse mortgage that can provide a lump sum, monthly payments or a credit line you can draw on as needed.
Or, if you’d like to protect yourself from the possibility that you’ll spend too much early in retirement and end up with little or no savings in your dotage, you can always invest a small portion of your nest egg in a “longevity annuity” that begins making payments late in life, say, at age 75 or older.
Bottom line: Over the course of a long career and a lengthy retirement, it’s virtually impossible to predict the path the economy, the markets and your finances will take. Faced with such uncertainty, it almost always pays to hedge your bets.