Retiring comfortably is a dream for many, but it often feels out of reach in a world of economic uncertainty and fluctuating markets. Typically, the strategy is to build as much wealth as possible during your working years, and then slowly spend it to fund your retirement years.
There’s nothing wrong with this strategy, but if you hope to leave something behind for your loved ones, you may not like the idea of burning through your savings in retirement. If that’s your goal, it’s possible – but not easy – to fund your retirement off of the interest generated by your investments alone.
The term interest is used somewhat loosely here. Interest specifically refers to what you pay for the privilege of borrowing money, or what you are paid in return for lending it. In this context, we expand the definition to include passive income, usually fixed and/or predictable, from a variety of sources – not just things like savings accounts, but also bonds, stocks, and annuities. Interest is expressed as a percentage that gets applied to your principal. As a simple example, let’s say you have $1,000 invested in something that offers 5% interest annually. That means you get paid $50 a year.
Start by Accumulating Principal
There’s no way around it – you are going to have to accumulate a lot of money if you want to live off of the interest it generates. A 5% yield on a million dollars would pay you $50,000 a year – for many that won’t be enough to live on. Yields will only ever go so high, so you can’t count on higher rates to do the work for you.
One way to plan is to estimate what you need to live on and work backward from there. If you need $80,000 a year and expect to get around a 6% yield, you’ll need a little over $1.3 million in principal to do it (divide the annual payment by the yield to get the total).
Protect Your Principal
It’s crucial to understand the importance of protecting your principal. Since your payments are dependent on the size of that initial investment, you have to preserve it while it generates interest. That means you need to think very carefully about the investments you choose – don’t take on too much risk just to chase a higher yield.
Beyond that, you should make sure you have an emergency fund outside of your interest-generating investments. If an unexpected major expense arises and you’re forced to use your principal to pay it off, that will shrink your annual payments and possibly put your entire strategy at risk.
Savings Accounts and CDs
Most people are familiar with savings accounts and certificates of deposit (CDs), as they are among the safest options for generating interest income. These are offered by banks and credit unions, and they are typically insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). While these accounts offer a high level of security for your principal, they generally offer lower interest rates than other investments, and in the case of CDs, your principal is locked up for a fixed time period, meaning you can’t access the money if you need it.
It’s unlikely you’ll be able to live off of the interest generated by traditional accounts like this, so you’ll need to consider other investment vehicles. Independent financial advisor Steven Conners, the founder and president of Conners Wealth Management, shared some ideas on how to live off of your interest payments.
Bonds are a debt security that is issued by corporations and governments in order to raise money. “Taxable corporate bonds pay interest every six months and can provide you with a favorable steady stream of income. You can still receive monthly income by staggering the months you receive interest. So, if you buy a corporate bond paying in January and July, then the next bond would need to be paid in February and August, and so forth,” Conners said.
Conners also noted that it may make sense to use tax-free municipal bonds which are exempt from state and federal income tax. If you purchase bonds from the state in which you reside or live in and it has no state income tax, tax-free municipal bonds may be a better choice. This is more advanced, so be sure to consult a tax professional if you’re not sure.
Fixed Index Annuities
Fixed Indexed Annuities (FIAs) are insurance products that offer a combination of safety and the potential for interest income. “The main reason one should look at annuities is if they’re concerned about longevity risk. Many Americans are living much longer during their retirement and the promise the insurance companies make is that you cannot outlive your monthly income,” Conners said.
Preferred stock is a hybrid investment that combines elements of both common stock and bonds. Preferred stockholders receive fixed dividend payments, making it a reliable source of interest income.
“A preferred stock pays interest just like a bond, but dividends are paid every quarter. The capital invested is always liquid given that preferred stock is listed on the New York Stock Exchange. Typical yields are very competitive and have a yield that is higher than 30-year Treasury yields,” Conners said.
For investors who are comfortable with the volatility and uncertainty of the stock market, there are some dividend-paying companies whose stocks offer a high yield. Common stock is by far the riskiest way to allocate your principal, but it offers unparalleled liquidity, and unlike other options, common stock offers the chance for principal growth in addition to income.
“Companies that often pay competitive dividends are utility companies, which may be very similar to bonds in that growth for many utility companies is muted but may pay competitive dividend yields. Other industries may include real estate investment trusts, also known as REITs. The value of the underlying real estate and occupancy rates for buildings, apartments, long-term care facilities, etc., needs to be evaluated first, as with any investment,” Conners said.
Remember To Diversify
Your specific strategy should be tailored to your specific situation – but no matter what you invest in, make sure you are employing good risk management techniques. One of the best is diversification, which simply means spreading out your investments among a number of different options so that you aren’t concentrating your risk.
“At the end of the day,” said Conners, “investors may want to include all of the different strategies mentioned above and even include some short-term Treasury Bills and three- to five-year certificates of deposits (CDs) to help round out their respective portfolios.”
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