The road to an interest-only retirement

Shelly Gigante

By Shelly Gigante
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
Posted on Jan 6, 2020

For many retirement savers, it defines success: the ability to live off their interest income alone after they exit the workforce.

A portfolio that produces enough passive income to cover your living expenses without having to invade principal (the amount of money you invested) guarantees that you won’t outlive your assets, at least in theory. It also preserves the value of your estate for future heirs.

But what does it take to engineer an interest-only retirement? And with fixed-income yields still hovering near historic lows, is it possible to achieve that goal without assuming greater risk?

“It’s definitely possible, depending on your portfolio size and your income needs,” said Roy Janse, a financial professional with DeHollander & Janse Financial Group in Greenville, South Carolina. “It’s really a simple equation. If you need $40,000 to live off of and you have a $1 million portfolio that earns a 4 percent yield, which is about what you’d expect without getting into higher risk investments, it’ll work. But if your portfolio is not of the magnitude to produce that income, or your expenses are too high, then it won’t.”

The magic number

To determine how big your portfolio must be to cover the bills with only your investment returns, grab a calculator.

Plug in the amount of annual income you think you’ll need during your retirement years and divide that figure by your projected yield (or earnings). For example, if you need to replace $100,000 per year in income and you expect to earn 2.5 percent on your investments, you’ll need $4 million saved ($100,000 / .025 = $4 million).

The calculation changes considerably if you can achieve a higher yield, said Matt Chancey, a private wealth manager in Tampa, Florida. By earning 5 percent per year, for example, you could generate the same amount of annual income ($100,000) with half as much saved—$2 million. “That’s a big difference,” he said.

Take note that you may not need as much saved if you have other sources of income, including pensions, Social Security, or trusts.

“If you expect to receive $40,000 of annual Social Security income, and need $100,000, you now only need to replace $60,000 of income, which is possible with $1.2 million of saved capital (assuming your investment yields 5 percent),” said Chancey.

To earn a higher return, however, you’ll need to assume greater risk.

Retirees once relied heavily on the relative safety of fixed-income securities (bonds and certificates of deposit) to produce predictable income with little to no risk. Certificates of deposit (CDs), a federally-insured savings account, offered double-digit interest rates in the late 1970s and 1980s. And long-term Treasury bonds, which are issued and backed by the U.S. government, could reliably be counted on to generate 5 percent (or better) returns as recently as 2003. But those days are gone.

Interest rates today remain at rock bottom, with Treasury bonds yields and five-year CD interest rates offering roughly 2 percent each, barely above the current 1.8 percent rate of inflation. Living off the interest of fixed-income securities today is nearly impossible for all but the biggest portfolios.

Inflation risk

According to Janse, ultra-conservative investors must consider the opportunity cost. By keeping their money in low-yield securities, they slash their income potential and limit the value of their future estate. They may even lose purchasing power if the securities they own earn less than the rate of inflation.

Inflation pushes up the cost of goods and services over time, which erodes the value of investments and savings.

During the past 30 years, the inflation rate has averaged from 2 percent to 3 percent per year. For perspective, that means that the same item that costs a new retiree $1,000 today would cost them roughly $2,100 in 30 years.

“If you want to stay ahead of inflation, you have to achieve 3.5 percent or 4 percent returns at a minimum,” said Chancey.

The right strategy for you

There are literally dozens of retirement income strategies that exist and choosing the one that’s right for you is determined by what you are trying to accomplish and your tolerance for risk.

Janse said he counsels retirees who seek to maximize their yield to consider a mix of different asset types, including fixed-income securities to protect against stock market downturns, dividend-paying stocks with steady returns, and even potentially rental income from real estate. (Related: Understanding the basics in investing)

Stocks offer the potential for higher returns, but involve greater risk.

Over the past century, stocks have produced an average return of about 10 percent per year, compared with long-term government bonds, which have returned from 5 percent to 6 percent.But the equity market offers no guarantees. Those who invest in stocks must be prepared for performance volatility, and the possibility that they could lose money. Not all retirees are comfortable putting their nest egg at risk. (Related: Why identifying your risk profile is essential to investing)

One way to mitigate risk (and help you sleep at night) while reaching for higher returns is to segregate your portfolio into three distinct buckets, said Janse. This hybrid solution places near-term assets (needed in the first three to five years of retirement) in low-yield, conservative investments, such as money markets and savings accounts or Treasury bills.

The next bucket, earmarked for use in retirement years six through 10, can be locked up in certificates of deposit or conservative bonds, such as Treasury bonds, and potentially corporate bonds from “very solid cash-rich companies” to produce a slightly higher rate of return, he said.

The final bucket would be designated for conservative dividend-paying stocks that provide a regular income and have the potential to deliver greater returns. The quantity and type of investments that would be used in each bucket would highly depend on the retiree’s risk level and their potential need for future lump-sum withdrawals, among other factors, and therefore could vary significantly.

According to Chancey, those who seek to preserve their estate for the next generation, even if it requires downsizing their lifestyle, are good candidates for an interest-only portfolio.

“The premise is to never kill the golden goose and live off the golden egg,” he said. “Not everyone can accomplish that, but it’s a great target to shoot for.”

Permanent life insurance, like a whole life insurance policy, can offer an additional backstop for a retirement portfolio. During market downturns, it may be possible to use a policy’s cash value for living expenses, preserving investment principal to capitalize on an eventual market recovery. (Learn more: How life insurance can help you in your retirement)

To annuitize or not

Annuities, which are contracts issued by an insurance company that provide guaranteed payments either immediately or at some point in the future in exchange for an upfront lump-sum payment or series of payments, are another way to potentially boost your income in retirement. But they aren’t necessarily right for everyone.

“It can be great for a yield-only strategy because it offers more guarantees, but if you need $20,000 for a new roof or car, you may not have access to the principal,” said Janse. “Generally, I wouldn’t recommend investing all your liquid assets into an annuity. “

An annuity investment can be converted into a series of periodic income payments. Annuities may be annuitized for a specific period or for the life of the annuitant, essentially guaranteeing an income stream for all or a portion of retirement years. And apart from guaranteed income, the two other benefits of annuities are tax-deferred growth and creditor protection. (Related: Does an annuity fit your retirement goals?)

“A person who might be a great fit for an annuity is a physician because [health care is] a litigious industry and the money that gets put into an annuity tends to be protected from creditors, depending on the state and jurisdiction,” said Chancey.

Similarly, retirees with significant assets may wish to consider an annuity, because interest earned from bonds and dividend-paying stocks could potentially cause their Social Security benefits to be excessively taxed, or push them over the income threshold to where their Medicare premiums would increase.

“If they owned an annuity and allowed their income to accumulate there instead, there could be substantial tax savings,” said Chancey.

By contrast, those who seek to preserve their estate for the next generation might lean more heavily toward an interest-only portfolio, even if it requires downsizing their lifestyle.

“For people with more of a legacy goal and those who can’t sleep at night with their savings at risk, a yield-only retirement can be a good option,” said Janse.

If your retirement goals include preserving your principal, an interest-only retirement may be an attainable goal. A financial professional can help you determine how much savings you’ll need to set aside and recommend an investment strategy that produces an adequate yield, while taking low interest rates and inflation into account.

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Zacks Investment Research, “The Long-Term Rate of Return for Bonds Vs Stocks,” May 31, 2019.

The information provided is not written or intended as specific tax or legal advice. MassMutual and its subsidiaries, employees, and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of MassMutual.