Most people look forward to the day when they can stop working and enjoy the fruits of all their hard work. However, when you give up your salary, you will need to find a new source of income to support yourself in your golden years. Everyone has a different retirement planning strategy, but it usually includes a diverse portfolio of retirement funds, savings, and investments. If you are fortunate, you can also include your social security payments and pension to your monthly retirement income. If you invest wisely, it is possible to live solely on interest earned from your assets…in theory. However, there are some serious flaws in this plan. Here are a few things to consider if you want to adopt this approach to investing.
The Principal Principle
This planning strategy depends upon the “principal principle.” Simply put, if you plan to live solely on interest, you cannot touch the principal amount. Since you will use the entire sum to generate income through interest, you do not want to undermine your earning potential. If you withdraw from the principal, you are working against yourself. A declining principal balance equates to declining income during your retirement years. If you continue to dip into the principal without adjusting your budget, it will erode your nest egg. This leaves less money in the later years of retirement when expenses typically increase.
Determining How Much You Need to Save
Even if you are not certain that you can survive solely on the interest your investments earn, you can still get an idea of how much money you would need to make it work. The formula is simple, and an excellent starting point to calculate your financial needs in retirement.
First, you need to estimate how much income you need to meet your expenses. Most retirees spend less once they stop working, but you should still plan for 70-90% of current expenses. Next, you need to decide on your interest rate. Conservative investors usually set the amount between 1-3% while more optimistic people aim for 3-5%.
Once you have the figures, the math is simple. To find your savings goal, divide your estimated annual income by the interest rate. For example, if you set your income at $60,000 a year with a 3% interest rate, your savings goal is $2,000,000. Keep in mind everyone’s needs differ, so you this amount varies based on your personal circumstances.
| Apps | Fees and Minimum | Best For |
|---|---|---|
| Digit | 30-day free trial period. $5 per month | Setting aside automatically. |
| Acorns | $1 per month | Spare change investing. |
| Qapital | $3 membership | Letting you set rules to automate savings. |
How It Is Possible to Live Solely on Interest
The interest-only approach is possible if you have excess capital to invest. Unfortunately, this strategy is problematic for most Americans. According to the TransAmerica Center for Retirement Studies, the average baby boomer (the generation closest to or entering retirement now) only has $152,000 in retirement funds. This does not leave a lot of room to take large financial risks.
Before you commit to living solely on interest, you must consider the average yield you will need to support yourself. Most financial advisors will recommend boosting your portfolio’s yield with various types of bonds. Laddering your bonds lets you stagger their maturity dates, and hedge against the risk of large fluctuations. Then, you can reinvest or reallocate the funds when they become available as well.
Mutual funds could generate enough income to live solely on interest. But, this requires steady and predictable returns. Unfortunately, this is not the best option if returns are inconsistent. You can also look into deferred annuity accounts which offer higher interest rates and greater security.
The Pitfalls of the “Principal Principle” Plan
If you plan to live solely on interest, there are a few things you have to keep in mind. First, you must take into account the impact of taxes. You need to know if your investments will be tax-deferred and how this will affect your retirement income.
Furthermore, many people forget to account for inflation. Over time, inflation reduces your purchasing power and could erode from your principal amount. You can estimate inflation rates based on your expected life span and income requirements at the end of your retirement years. However, fixed-income securities have little protection against inflation beyond the Treasury Inflation-Protected Securities (TIPS). This is why you need excess savings to counteract inflation.
While it is possible to sustain retirement income with the interest-only strategy, most experts will advise you to diversify your portfolio. More diversification means you are better prepared for retirement and less likely to run out of money when you need it most.
| Apps | Fees and Minimum | Best For |
|---|---|---|
| Betterment | 0.25% per year no account minimum | Saving for retirement |
| Ellevest | $1-$9 per month no account minimum | Retirement especially for women |
| Personal Capital | Free | Planning retirement |
Read More
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- Taxes Can Make or Break Your Retirement
Jenny Smedra is an avid world traveler, ESL teacher, former archaeologist, and freelance writer. Choosing a life abroad had strengthened her commitment to finding ways to bring people together across language and cultural barriers. While most of her time is dedicated to either working with children, she also enjoys good friends, good food, and new adventures.