Is an Interest-Only Retirement Possible?

As retirement options go, what is often presented as ideal is interest-only income. In theory, it seems simple. You invest your savings in interest-bearing assets. Whatever interest you earn is the money you spend in your golden years.

Say you retire with a $1 million nest egg and park it all in fixed-income investments that generate 6% annually. That's $60,000 per year in interest, plus Social Security and a pension if you're lucky. When you die, your surviving spouse or heirs receive the entire $1 million sum you started with.

What could be better? As it turns out, there are a few serious flaws to this approach. We discuss these below, along with some smart moves to get past them.

Key Takeaways

  • The interest-only retirement strategy means you can't touch the principal. For this to work, you'll need a separate emergency fund to cover unexpected expenses.
  • 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 should be kept out of reach. Think of this as the principal principle. You need the entirety of your principal to create income, otherwise a declining principal balance will create a declining level of income.

Let's say you seed your interest-only strategy with $1 million, but then need to spend $30,000 on a new car or roof repairs. Now you're left with $970,000 in principal. As a result, your 6% annual investment returns will net $58,200 in yearly interest income, instead of $60,000 per year.

If you fail to lower your budget by $1,800 and continue spending $60,000 per year, the principal will erode further, and do so every year for the rest of your life. In year two, what was $970,000 in principal dwindles to $968,200. In year three it becomes $966,400, and so on.

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How To Build A Retirement Plan

When Interest-Only Works

An interest-only strategy can work for those who posses excess capital. Let's stick with our previous scenario of $1 million saved for retirement earning 6% annually. If your supplemental income needs are $55,000 per year, that means you need $917,000 in principal to produce your income. This leaves $83,000 in excess capital available for emergencies or irregular expenditures.

Consider laddering bonds. That is, buy bonds with different maturity dates in order to reduce interest rate risk.

The first consideration is the average yield you'll need to earn. If you need $25,000 per year in income and have $500,000 to invest, divide $25,000 by $500,000 (25 ÷ 500) to get 0.05, or 5%, as your cash-flow requirement.

You'll also need to consider the impact of taxes and whether your investments are held in a tax-deferred account or not. Certain types of fixed-income securities may or may not be appropriate.

Shopping for the Right Yield

Once you've determined the yield you'll need, it's time to shop. Even though a fixed-income security may offer a yield lower than your target, it could still fit within your overall portfolio. In order to boost your portfolio's average yield, you can look to several types of bonds such as agency, corporate and even foreign bonds.

Ultimately, investors need to be aware of the risk inherent with each type of bond, including default risk, interest rate risk, inflationary risk, event risk and the risk of large price fluctuations. You can even lose money with a Treasury Bond if you sell at the wrong time.

In addition to diversifying the types of bonds in your portfolio, you can and should also purchase bonds with varying dates of maturity. This is called laddering. The strategy helps to hedge against some of the aforementioned risks by periodically making funds available for reallocation.

Mutual Funds and Interest-Only

Some investors turn to mutual funds for their interest-only strategies, but this isn't ideal if the interest income is inconsistent. Theoretically, it could work, if the returns are level and predictable. But since bonds mature, the interest payments generated from a bond mutual fund don't always stay the same.

When interest payments drop, you'd likely be forced to liquidate your mutual fund shares, which is akin to a systematic withdrawal plan and a violation of the principal principle. Though investing in bond mutual funds is easier than building a portfolio of fixed-income securities, it doesn't provide the same benefits.

Deferred Annuities

Another useful tool is the fixed deferred annuity. This type of annuity is an interest-bearing account with characteristics similar to a certificate of deposit (CD). Interest rates on fixed annuities are frequently higher than CDs and Treasuries. They also provide a high level of safety.

Though most annuities guarantee principal and interest payments, they are not insured by the Federal Deposit Insurance Corporation (FDIC).

Remember: 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, a fixed deferred annuity is preferred. 

The Hidden Problem: Inflation

Over the past two decades, inflation has ranged from 0.1% to as much as 3.8% per year. In our original scenario—the retiree with $1 million and a 6% yield—we ignored the impact of inflation. Unfortunately, this retiree might also experience portfolio erosion, because $60,000 doesn't buy as much in year two as it did in the initial year. 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 protection against inflation, with the exception of Treasury Inflation-Protected Securities (TIPS).

This is also why you really need excess savings to do an interest-only retirement strategy 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 an element of a "rainbow" to them.

A rainbow covers the entire color spectrum. A rainbow portfolio should be well-diversified and cover the spectrum of possibilities. Use many types of securities and stagger the maturities to create a ladder.

Be thorough and careful when crunching the numbers. Interest-only portfolios can work, but if you aren't careful you can find yourself without adequate retirement funds.