Is an Interest-Only Retirement Possible?
As retirement income plans go, the option that is often presented as the ideal is the interest-only income. It's certainly the simplest, in theory. You invest your savings in interest-bearing assets and whatever interest they earn is the money you spend.
Say you retire with $1 million in savings and invest it all in a portfolio of fixed-income investments at 6% and live off of the interest. That's $60,000 per year plus Social Security and a pension if you're lucky. After your death, your surviving spouse or other heirs get the entire $1 million you started with.
What could be better? As it turns out, there are some serious flaws to this approach. Here they are, along with some smart ways to get past them.
- The Interest-only strategy means you can't touch the principal. You'll need an emergency fund, too, for this to work.
- Consider inflation. Your income target should be based on the last years of your life, not the start of your retirement.
- Having a diversified bond portfolio and using a laddering strategy are key to mitigating risk.
The Principal Principle
For starters, interest-only means interest only. The principal is permanently out of reach.
This can be referred to as the principal principle. You need all of the principal to create the income unless you want a declining principal balance and a declining income.
Let's say you implement this strategy and then need to buy a car or put a roof on the house. You have to withdraw $30,000 to do it. Now you're left with $970,000 in principal.
As a result, your income will decline from $60,000 per year to $58,200. If you try to maintain your current lifestyle, the principal will continue to decline every year for the rest of your life. In year two, your principal will fall to $968,200, and you'll have to dip into it a little more to make ends meet.
How To Build A Retirement Plan
When Interest-Only Works
A true interest-only strategy can work only for those with excess capital. If you retire with $1 million but only need $55,000 per year of supplemental income, keeping with our 6% assumption, you will need $917,000 to produce your income. That will leave you with $83,000 that can be used for emergencies or irregular expenditures.
Consider laddering bonds. That is, buy bonds with different maturity dates in order to reduce rate risk.
The first consideration is the average yield of the portfolio. If you know you need $25,000 per year and you have $500,000 to invest, then divide $25,000 by $500,000 (25 ÷ 500) and you'll get 0.05, or 5%, as your cash-flow requirement.
Shopping for the Right Yield
Once you've determined the yield you need, it's time to go shopping. Even though the yield on a fixed-income security may be lower than your target, it may still fit as a piece of your portfolio. In order to boost the average yield, you can look to other bond types, like agency, corporate, and even foreign bonds.
Ultimately, each investor needs to be aware of the risk inherent in each type of bond, such as the risk of default, market risk, and the likelihood of large price fluctuations. You can even lose money with Treasuries if you sell them at the wrong time.
In addition to diversifying the portfolio by type of bond, you can and should also buy bonds with varying maturities. This is called laddering. The strategy helps you hedge against some of the aforementioned risks.
Mutual Funds and Interest-Only
Some investors try to use mutual funds for their interest-only strategies, but this is not really interest-only. Theoretically, it could work, so long as the funds being used pay out a consistent amount of interest. But since bonds mature, the bond mutual funds' interest payments don't stay the same.
Investing in a portfolio of mutual funds is easier than building a portfolio of fixed-income securities, but it does not provide the same benefits.
Another useful tool is the fixed deferred annuity. This type of annuity is an interest-bearing account with similar characteristics to a certificate of deposit (CD). The interest rates on fixed annuities are frequently higher than those of CDs and Treasuries. They also provide a high level of safety.
Annuities are not Federal Deposit Insurance Corporation (FDIC)-insured, though most have guaranteed principal and interest.
Remember that there are many types of annuities. For an interest-only strategy, a fixed deferred annuity is appropriate. A fixed immediate (income) annuity is not. Nor is a variable deferred or a variable immediate annuity.
You want predictable interest coupled with safety of principal. Immediate annuities use up the principal and variable annuities, like mutual funds, can decline (or increase) in value.
Each type has its place, but for an interest-only strategy, fixed deferred is the one.
The Hidden Problem: Inflation
Historically, the average rate of inflation is about 3% per year. In our original scenario—the retiree with $1 million and a 6% yield—we ignored its impact. Unfortunately, the person in that scenario might also experience portfolio erosion because, in year two, $60,000 doesn't have as much spending power as it did in year one.
This is critical. We don't want to accidentally violate the principal principle.
Some people decide up front to allow some erosion. The only way to do that is to inflate your income requirement by estimating the cost of living at the end of your life expectancy, not at the start of your retirement years.
This is a big strike against the interest-only strategy. A portfolio of fixed-income securities offers little to no opportunity for inflation protection, with the exception of Treasury inflation-protected securities (TIPS).
This is also why you really need to have excess savings to do interest-only properly.
The Bottom Line
Ideally, if you've done your homework and have accurately concluded that interest-only is not only doable but sustainable, you'll want to blend your holdings, using bonds, CDs, and annuities. All portfolios, regardless of strategy, should have elements of a so-called rainbow in them.
A rainbow covers the entire color spectrum, which means that a rainbow portfolio should be as well-diversified as possible. Use many types of securities and stagger the maturities to create that ladder.
Be thorough and careful when crunching the numbers. Interest-only portfolios can work, but if you aren't careful with the details you can find yourself without adequate retirement funds.