A recent US retirement survey from Schroders highlights that more investors are interested in private market assets despite a significant knowledge gap. Retirement investments have evolved significantly in the past couple of decades. Steering ahead of traditional investment vehicles like bonds, mutual funds, and stocks, many retirees choose alternative investments for retirement portfolio diversification to enhance returns and secure their financial future.
Through this blog, we will explore the potential pros and cons of alternative investments in retirement planning, their return, and their effect on financial planning.
Alts are financial assets that aren’t included in the traditional investment categories of cash, bonds, or stocks. Some common alternative investments are real estate, hedge funds, private equity, and commodities. These investments include cryptocurrencies and collectibles like art, antiques, rare coins, and wine. One of the distinguishing features of alts is that they have a low correlation with the traditional asset class and operate independently in the financial market. In other words, when the market turns volatile for the usual or standard asset class, these investments remain unaffected and flourishing!
In retirement financial planning, alts can be best incorporated into a self-directed Individual Retirement Account (IRA). Doing so will enable easy investments in a wide range of assets while enjoying tax benefits associated with retirement accounts. However, alts require a high level of expertise for retirement investing as it has pros and cons. Let’s learn about them in detail.
1. Diversification beyond traditional assets:
Alts increase the options for retirement portfolio diversification. This asset class isn’t affected by market volatility, thereby reducing the overall portfolio risk and ensuring better risk-adjusted returns. Furthermore, these investments allow broader exposure to different geographical regions and economic sectors, further boosting diversification. They offer a mix of income, growth, and defensive assets.
2. Potential for higher returns
Certain alternative retirement fund options, such as private equity, real estate, and venture capital, can offer the maximum returns, especially if the investments are executed well. For example, purchasing equity in a small startup or funding a small business can yield substantial returns if the companies perform well and grow rapidly. Similarly, a real estate property can guarantee a capital appreciation and rental income that can easily outpace any traditional asset.
3. Hedge against inflation:
One of the key requirements of retirement investing is preserving purchasing power over time. Traditional assets struggle to keep up with high inflation. However, by increasing the asset's value with the rise in inflation, alternative investments provide a natural and effective hedge. For instance, the values of commodities like agricultural products, oil, gold, and real estate classically increase due to a hike in demand and rent.
4. Regular income generation
Alternative retirement funds from real estate, infrastructure avenues, and Real Estate Investment Trusts (REITs) can provide a consistent income stream that is beneficial for retirees. These assets help them in maintaining a steady cash flow required to cover their living expenses or desired lifestyle, when salaries are no longer available.
Wondering how? Well, REITs pay out large chunks of their income as regular dividends to investors. These dividends later become reliable income sources sans the need to handle or manage properties directly. Similarly, investments in infra projects like utilities, roads, and tolls, bring long-term and stable income through service charges or user fees, all of which encompass a crucial component of a retirement financial plan.
5. Tax benefits:
Some alts enjoy favorable taxation treatment, for instance, certain collectibles or deductions in the devaluation of real estate properties. Another attractive tax feature of alts lies within retirement accounts like self-directed IRAs. Whether you opt for a Roth IRA or a traditional IRA, you can avail significant tax advantages. Both tax-free growth and tax deferral enhance overall returns by compounding your retirement investing, especially alternatives.
Alternative investments can provide significant returns but come with higher risks and are more unpredictable than traditional assets. For instance, the highly cyclical real estate markets can be hit by a severe downturn, declining property values, and rental income. Also, the volatility can fluctuate the commodity market and private equity investments based on geopolitical events, market conditions, and other factors.
1. Illiquidity:
Unlike stocks and bonds, alts like private equity and real estate cannot be quickly exchanged for cash. In a retirement investing context, illiquidity can pose challenges with limited opportunities for those who require access to their investments for further financial planning or to cover unexpected expenses.
2. Complexity and lack of transparency:
Alternatives are complex investment vehicles that require specialized knowledge and understanding. An average retiree might not understand the market dynamics and investment strategies very well. For instance, private equity investments are subjected to intricate valuations and deal considerations that may be difficult for an average retiree to understand.
Furthermore, when compared to publicly traded stocks or bonds, alts like hedge funds lack transparency, which makes monitoring the performance of alternative retirement funds more challenging.
3. Regulatory and legal considerations:
Any regulatory change can severely impact the financial planning of retirees. If your alternative retirement funds include hedge funds, private equity, and real estate, you must know that any change from the government can affect the profitability of these industries.
Retirement portfolio diversification requires careful legal considerations, too, especially within a self-directed IRA. The IRS presides over all investments within an IRA, and any violation can either disqualify your retirement account or result in hefty fines.
4. Valuation challenges:
Ascertaining the accurate value of alternate retirement assets can lack clear valuation metrics, leading to investment risk and potential mispricing. For instance, in the case of collectibles, the value is subjective to the item's condition, rarity, and, most importantly, the buyer's interest. Similarly, real estate appraisals are subjected to fluctuations in market conditions, location, and property-specific factors.
Alternative investments can offer unique retirement portfolio diversification options for retirees potentially hedging against market fluctuations and promising higher returns. With assets like commodities, real estate properties, and private equities in a self-directed IRA, retirement investing can be tailored for better financial planning by considering risk tolerance and specific goals. However, dealing with alts involves several risks like complexity, high fees, and potential for illiquidity, therefore, it is imperative to weigh them before investing.
At PCR Insights, we highly recommend a balanced approach for retirees to navigate the challenges and opportunities offered by alternative investments. Our expert financial advisors can help you make informed decisions about including alts in your retirement investing.
Contact us to enhance your retirement portfolio diversification and increase your possibilities of secure and prosperous financial planning.