For many people retirement is still decades away, but it's never too early for investors to begin saving and implementing a multilayered approach to retirement planning.
The sooner you start saving and investing money, the more time your capital has to work for you. While many workers may rely on either stocks or bonds to build a retirement portfolio that is capable of producing enough cash flow to fund their living expenses, investors actually have a variety of income sources at their disposal.
Retirement resource pyramid
Consider the following retirement pyramid, which includes a set of cash flow sources that investors can tap to fund their lifestyle in advanced age.
Government income sources
The pyramid approach to retirement planning uses all possible sources of income.
The bottom layer of the retirement resource pyramid consists of guaranteed income from the U.S. government, including Social Security benefits, pension income, and annuity products.
This layer is characterized by a relatively low degree of risk involved: Social Security income from government sources is usually considered to be of very low risk and of very high quality.
The second layer consists of other long-term assets, including home equity which plays a large role for retirement planning purposes. Besides the obvious stability of living rent-free in your own house or apartment, a home without a mortgage also offers investors the necessary piece of mind to enjoy their retirement.
This layer also encompasses traditional retirement vehicles such as IRAs or 401(k)s and insurance annuity products.
Though all of these avenues involve relatively low risk, especially when considered over long investment horizons, they carry more uncertainly than government income sources in the bottom layer.
Investors will run into health problems at some point as they age, and the "health theme" deserves appropriate attention.
Investors can most easily mitigate the effects of expensive medical treatment by taking out insurance that both covers them and provides financial security for family members in the case of a severe illness or death.
Investment portfolio and diversification
The fourth layer is increasing in importance for investors -- a structured approach to retirement planning is paramount. The easiest thing investors can do to save for their own retirement is to take advantage of time and the power of compounding. In other words: start to save while you are still young.
Many investors and retirement planners remember the recent housing bubble very vividly. Such events can set back investors many years in their retirement plans, as the second layer of the pyramid (including real estate values) was adversely affected by the distress in the housing market.
it is also of paramount importance for investors to diversify their investment holdings across equities, bonds, and mutual funds. Diversification is key in mitigating the fluctuations of the capital markets, and the less time investors have until retirement the more diversified their investment portfolio should be.
The Foolish takeaway
Investors need to develop a holistic view of retirement planning and understand the multitude of income sources from which they can draw cash.
The pyramid approach enables investors to better understand and prepare for retirement planning. Using all layers in the pyramid also puts investors' retirement on much more robust footing.
Moreover, investors should not underestimate the relatively "small" component of savings at the top of the pyramid. Though this layer appears small compared to the bottom layer, a solidly diversified investment portfolio across asset classes can make all the difference for successful retirement planning.