Introduction to Investing for Retirement: Types of Asset Classes and Retirement Plans


June 4, 2021

Introduction to Investing for Retirement: Types of Asset Classes and Retirement Plans

June 4, 2021

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There is no one formula for building a successful retirement plan—there are seemingly endless options and plans for you to invest in and take advantage of, with more being added all the time. The financial services industry is dynamic, ever changing and evolving as the economy progresses and technology advances. Understanding the different types of investment assets can help you sort through your options to make wise investment decisions.

To understand asset classes, it’s important to understand the level of risk associated with each. Some sources call this the investment “risk ladder,” which places every asset class on a scale according to relative riskiness. Cash is the most stable and least risky while alternative investments, like commodities, real estate, collectibles, private equity, and venture capital, are the most volatile or risky.

Cash is the most easily relatable and simplest investment form, as we’re all well acquainted with it and use it on a regular basis. Cash is also the safest option—you deposit money into a checking or savings account, know exactly how much interest you’ll earn on it, and have the ability to maintain your capital. It’s also the most liquid investment, meaning you can obtain cash with the push of a button with no impact on its value. However, one major issue with keeping all your retirement money as cash in the bank: The interest earned will almost surely not beat inflation rates, and you’ll earn much lower returns than you would by investing in other asset classes. Certificate of deposits (CDs) are savings accounts that hold a fixed amount of money for a fixed period of time in exchange for a specified interest rate. When you cash it in, you receive your original principal plus an earned interest. They are also highly liquid and have higher interest rates than a standard bank account but almost always come with early withdrawal penalties. Both cash and CDs are some of the safest investment options.

The money market is another safe and liquid investment but, again, with relatively low return rates. According to Investopedia, the money market refers to “trading in very short-term debt investments,” like overnight reserves or commercial paper. “It involves overnight swaps of vast amounts of money between banks and the U.S. government. Individuals can invest in the money market by buying money market funds, short-term CDs, municipal notes, or U.S. Treasury bills.” Individuals can buy money market funds or open a money market account at a bank.

To fully understand the retirement investment landscape, we also have to discuss securities, real estate, and retirement savings accounts, too.

Securities

Securities are “a fungible, negotiable financial instrument” that has financial value of some sort. These are far too varied and specialized to cover in totality, but the most common vehicles are stocks, bonds, options, mutual funds, and exchange-traded funds.

Stocks represent an ownership stake in a company and can be divided into two categories: common stocks and preferred stocks. Owners of common stocks can usually vote at shareholder meetings and receive dividends. Owners of preferred stocks usually can’t vote but generally have a higher return on assets and earnings than common stockholders. Common stock has a high growth potential but may or may not pay dividends, while preferred stock is more likely to generate dividends but, in general, won’t grow in value at the same rate as common stock.

Over the long term, stocks have historically had the best return potential compared to US Treasuries but may experience more volatility (and potential money loss) in the short term. A shareholder can make money on stocks when 1) a stock appreciates in value, which you either sell or hold on to with unrealized gains, and 2) dividends, or payouts companies sometimes make as a reflection of its earnings. Dividends are not guaranteed—a company can start or stop paying them at any time. Despite stocks representing “ownership,” unless you own a significant portion of a company’s stock, you don’t really have a say in how the company operates. Keep in mind that selling stocks has tax implications: the length of time you hold a stock before selling can impact how the sale earnings are taxed. Those held for a short period of time (typically less than a year) are taxed as regular income, while those held for over a year in taxable accounts will generally be taxed at a lower rate.

Bonds are interest-bearing loans that an investor provides for the government or a company with a specific time and interest rate for repayment (think an IOU). Essentially, the investor provides capital at a fixed interest rate to the borrower to finance business operations or fund major purchases or projects. Bonds are generally issued at a fixed term (also called maturity date), meaning the borrower pays back the principal in full versus in incremental payments. However, the borrower pays the interest on the loan for the entire length of the term, so bonds can generate a steady and predictable income stream. Bonds sold prior to reaching maturity can increase or decrease in value on the open market, and the longer a bond’s term, the less likely it will be able to keep up with inflation (due to the fixed interest rate).

Bonds have typically offered lower returns than stocks, but they are more reliable with less volatility. According to Morningstar, since 1926, rates of returns for large stocks has averaged 10% while long-term government bonds have returned between 5–6% on average. A borrower’s ability to repay the loan introduces some risk into these investments, so it’s important to evaluate the company’s credit risk before purchasing a bond. Bonds can be purchased through a broker (just as stocks can be but with a higher transaction cost), but you can buy Treasury bonds directly from the Fed. Mutual funds are another great option for purchasing bonds as they allow you to diversify your portfolio in a way that purchasing individual bonds just can’t by allowing you to purchase stakes in many bonds as a fund holder.

Treasury Inflation Protected Securities or (TIPS) can hedge against inflation. This type of bond pays a fixed interest rate lower than regular Treasury bonds, but the bond’s principal is adjusted to keep up with inflation in the consumer price index. That is, as inflation rises, the face value of the bond rises.

Mutual funds are perhaps the most self-explanatory (and popular) of all—individuals pool their money together to purchase securities allocated via funds, allowing investors to purchase stocks, bonds, and other securities in quantities they might not otherwise be able to afford or access. This allows investors to diversify their portfolios, which is one of the greatest advantages of mutual funds. However, mutual funds are generally developed with a specific purpose or strategy in mind and can be concentrated in certain sectors or products—often without any feedback or perspective from investors. You can buy in to multiple mutual funds, but it’s important to evaluate the underlying securities to ensure you’re maintaining a diversified portfolio overall and not working against yourself (e.g., one fund sells the same stock another fund buys, charging you fees on both sides). Mutual funds have associated tax implications, even if you do nothing. Any time securities in the mutual fund are sold, investors owe taxes on any net capital gains.

Mutual funds are typically part of a mutual fund “family,” a company like Fidelity or Vanguard. This relationship provides investors many fund options to choose from. Index funds are designed to mimic indexes like the Dow Industrial Index or S&P 500, essentially buying into every stock on that index. These types of funds are not actively managed, in contrast to mutual funds that are actively managed by a portfolio manager, who make allocation and distribution decisions on behalf of investors and with associated management fees, which obviously increase as your portfolio value increases. Mutual funds’ values update at the end of the trading day based on their securities’ performance; all purchases and sales are executed at a fixed price after the market closes.

Exchange-traded funds or ETFs were introduced in the mid-1990s to combine the simplicity and low cost of index mutual funds with the flexibility of individual stocks. They are similar to mutual funds in that investors pool their money into funds that are managed by a money or fund manager; unlike mutual funds, ETFs can be exchanged or traded openly on the market throughout the day, essentially mirroring the behavior of stocks. ETFs can mirror market indexes like the S&P 500 or track any other set of stocks the ETF issuer wishes. These funds generally have very low fees, but you do have to buy them through a broker.

ETFs can be more volatile than mutual funds, considering they are more fluid as the market changes throughout the day; in general, investing in an ETF is a long-term investment, requiring discipline to stay the course despite short-term market conditions. Determining if you should invest in an index fund or index ETF comes down to how much money you have (or want) to invest: If you want to invest a large amount at one time—say, from a 401(k) or IRA rollover—an ETF might be the better option for you. Smaller and/or less frequent investments may do better in a regular mutual fund.

Alternative Investments

Investors can acquire real estate the traditional way—by directly buying commercial or residential properties on their own—or by purchasing shares in real estate investment trusts or REITs. REITs are companies that own and operate real estate. Investors pool their money in REITs and purchase properties together to provide an income for the fund owners. Many REITs are registered with the SEC and trade like stocks, but some may not be publicly traded. Understanding which type of REIT you’re investing in is important as each come with different risks and benefits. REITs are purchased through brokers and are often sold as a portfolio diversification tool. You can also purchase shares through a REIT mutual fund or REIT exchange-traded fund.

Investing in real estate can be a good way to generate retirement income, but it also comes with some risk. Cash flow from rentals and price appreciation when selling real estate can provide good returns, but property ownership comes with many expenses, like maintenance and repairs, taxes, management and legal fees, and those dreaded unexpected expenses (like vacancy rate when your property sits uninhabited). There’s also the risk that the property will depreciate in value with the ebbs and flows of the real estate market.

Private investment funds, like hedge funds and private equity funds, are pooled investment vehicles and are generally available only to accredited high-net-worth investors with a high initial investment—sometimes up to $1 million…or more. These are one of the riskier investments as there is no guarantee of a return or of overall performance. They are less highly regulated compared to mutual funds and have more latitude to use riskier investments and strategies. Do your research before investing in these types of funds—understand the fund’s prospectus, valuation, fees, managers/advisers, and limitations as a shareholder.

Commodities are tangible resources produced for the good of consumers. Examples include precious metals, agriculture, energy, oil, and food.

Collectibles are valuable items that tend to increase in value of time. They are often rare and/or in high demand with low supply. Collectibles can include artwork, jewelry, classic cars, stamps, coins, antiques, and wine.

Other alternative asset classes are foreign currency, derivatives (like futures, forwards, and/or options), venture capital, and distressed securities from companies at or near bankruptcy.

Retirement Savings Accounts

Retirement savings accounts are specialized investment accounts, often tied to your employer. Each plan has specific tax savings and/or implications. With these plans, you have a variety of investment options based on your retirement date, risk tolerance, and financial goals.

Traditional 401(k)s is an employer-sponsored plan funded with pre-tax dollars deducted from your paycheck, thus reducing your taxable income and deferring your taxes. Many employers have a matching program in which it matches a certain percentage of what you contribute (up to a certain limit). The money you’ve contributed continues to grow tax-free; upon withdrawal, you’ll be taxed at regular income tax levels.

Roth 401(k)s are very similar to traditional 401(k) with one major exception: Your contributions are made after taxes. The principal you contribute and any gains it generates—from interest, dividends, or capital gains—are not subject to taxes upon withdrawal. However, employer matches on this type of account must go into a traditional 401(k) as these funds haven’t been paid to you or taxed as income yet, incurring taxes upon withdrawal.

 IRAs are private individual retirement accounts. They differ from 401(k)s in that employers sponsor 401(k) plans, while IRAs are opened by individuals using brokers or banks. Contributions to traditional IRAs are tax-deductible, meaning you pay taxes upon withdrawal in retirement. Contributions to Roth IRAs are made after taxes; like Roth 401(k)s, earnings and withdrawals are tax free in retirement. SEP IRAs allow an employer to make contributions to an individual’s traditional IRA; this may be used by small business or self-employed individuals. Simple IRAs are generally used by small businesses who do not have 401(k) or other retirement plans available; these IRAs allow contributions from both employee and employer with lower costs and contribution limits.

A 403b is a retirement plan typically offered to employees of nonprofits, like schools and churches. Certain nonprofits and state and local governments offer 457 plans. Both plans allow employees to contribute pre-tax money to these accounts, which are then invested into a specific model; again, taxes will be due upon withdrawal in retirement.

In employee stock ownership plans (ESOPs), employers contribute company stock into the employee’s plan. This is not the same as employee stock options, which allow employees to buy their company’s stock at a set (generally reduced) price at certain times throughout the year. 

Defined benefit plans, also known as pensions, guarantee an employee a specific lifetime monthly benefit (an annuity) in retirement, regardless of fund performance. Alternatively, employees can take a lump sum payment upon retirement. Pension funds are pooled for employees, and some may have an employee contribution component in which the employer matches the employee’s contribution. These were once very popular but have fallen out of favor to be replaced by 401(k)s in recent years for two major reasons: They are expensive, and employers are on the line to cover the benefit if the fund doesn’t have enough money in it (perhaps during a market downturn).

Federal government plans include the Federal Employees’ Retirement System (FERS), Civil Service Retirement System (CSRS), and Thrift Savings Plan (TSP). Most federal employees have the option to and do participate in one of these plans.

Annuities

An annuity is a contract between you and an insurance company, who agrees to pay you a regular income now or in the future; annuities can be purchased with a lump sum or series of payments. Annuities provide a guaranteed lifetime income stream, eliminating the worry of outliving your money—and shifting this risk onto the insurer, who hedges their bets that the annuitant will die before their full principal has been paid out and by selling annuities to individuals at higher risk of dying prematurely (thus profiting). Annuities can be a beneficial addition to your retirement portfolio, but the varied types, investment principles, fees, taxes, and contracts are complex. Many attractive benefits (like death benefits) are optional “riders” that come at an additional—often expensive—cost. It’s important to understand your options and the fees associated with an annuity before purchasing.

By understanding asset classes and the benefits and risks they come with, you’ll be more prepared to choose the ones that fit your portfolio needs to build your wealth and retirement income. Take the time to learn more about your investment options—and take care to avoid the ones you don’t fully understand or enlist the help of a financial planner and/or advisor to help you sift through your options and educate and answer your questions. They can also help you craft a plan that focuses on growth, income, or a combination of both, depending on your current financial situation and where you are on the retirement spectrum. Your asset allocation and portfolio diversification can set you up for success—or on the path to failure. Investing for retirement is a journey—and a vital one at that. All retirement strategies come with benefits and risks, and with the proper education, planning, and help, you can watch your retirement assets grow with peace of mind that you’re on track in the race to retirement.


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