Income Alternatives for Retirees

There are other ways to generate income in retirement, though. In fact, you might find some of the alternatives more to your liking. While bonds will typically provide more income than the securities discussed here, these bond alternatives hold out the promise of higher long-term returns. They offer income and growth potential.

Why Not Bonds?
Bonds are the traditional retirement investment, because retirees can live off their income and simultaneously avoid the volatility of stock investments. The catch is that you have to have a lot of money in bonds to generate a sizable enough income stream to cover your retirement costs.

Say you need $50,000 per year to live on. You own an intermediate-term bond fund yielding 5%. You'd need to have $1,000,000 invested in that fund to receive $50,000 worth of income. And a few years down the road, you'll probably need more than $50,000 per year to live on, thanks to inflation. If that 5% yield was enough before, it may no longer be.

The following income alternatives will do a better job of keeping ahead of inflation than bonds--they offer more potential for greater overall return. They typically won't pay as much income as bonds, though. As a result, you will likely have to tap into your portfolio to meet your income needs.

Dividend-Paying Stocks
Many companies reinvest their profits to fuel future growth. Some mature companies, however, have limited growth potential. They may already dominate their industries and have little opportunity for expansion. Because of that, these companies pay out their profits to shareholders in the form of dividends.

You can either choose your own dividend-paying stocks or buy a mutual fund that focuses on these securities. Find a list of dividend-paying companies with a stock screening tool, like the one offered by Morningstar.com.

If you want to invest via a mutual fund, begin your search with large-value funds. Large-cap value funds tend to own well-established companies that have fewer opportunities for growth and therefore pay dividends.

Preferred Stocks
A preferred stock gets its name because its shares get preference when a company pays out dividends. These stocks are higher in the company's capital structure than ordinary or "common" stocks. In fact, preferred shares may offer dividends while common shares pay no dividend at all.

Is there a cost to preferential treatment? Yes. Preferred stocks offer less capital-appreciation potential than common stocks. Investors buy preferreds mostly for income, not for capital appreciation.

If you want to buy preferred stocks yourself, you'll have a tough road ahead of you. Unlike common stocks, preferreds can be difficult for individual investors to trade; institutional investors tend to trade the shares among themselves rather than on the open market.

A few closed-end funds, including John Hancock Patriot Preferred  focus on preferreds.

Convertibles
There are two types of convertibles: convertible bonds and convertible preferred stocks. Both are hybrids of stocks and bonds. Convertibles are income-producing investments that can be converted into shares of the company's stock. They offer much of the income of bonds with some of the capital-appreciation potential of stocks.

If you want to buy convertibles yourself, good luck. Thanks to the relatively small size of the market, do-it-yourself convertibles investing is well nigh impossible. We recommend that investors look into convertible-bond mutual funds instead. To narrow down a list of possible options, using an online tool such as Morningstar.com's Fund Screener. Morningstar.com Premium Members can read our  Fund Analyst Picks for ideas, too. (Nonmembers can sign up for a free trial to our Premium Service.)

Reap Capital Gains
Whether you explore these income alternatives or not, remember that your income in retirement does not have to come exclusively from dividends. Consider harvesting some of your capital gains to cover your living expenses--your income-generating securities may not generate enough income to cover all of your costs anyway.

In years when your investments have made especially strong gains, you may consider drawing out more than you need for living expenses and keeping the excess in a money-market account. That way, you can pull from that account when your funds are down and you need to supplement your income. You'll avoid turning paper losses into real ones.