Kevan provides his thoughts on interest-only retirement plans with Brian O’Connell and Emily Brandon of U.S. News & World Report
By Brian O’Connell | Edited by Emily Brandon | July 27, 2022
It’s not easy to live on your retirement portfolio’s investment interest.
An interest-only retirement plan aims to create a long-term investment portfolio that enables savers to live off the interest generated by their investments and leave the portfolio principal intact. Once the portfolio owner retires, the retiree should be able to live off the interest gained on the investments without having to touch the portfolio principal.
With an interest-only retirement plan:
- You live off the interest gained on interest-bearing investments.
- You need to figure out how much to save to be able to live off of interest earned.
- Factor inflation and potential bear markets into any interest-only planning equation.
- Bond laddering can be an efficient path to a secure an interest-only retirement outcome.
What is an Interest-Only Retirement Plan?
An interest-only retirement planning strategy involves investing in financial assets such as dividend stocks, bonds and funds over a long period of time. The retiree doesn’t spend the portfolio principal in retirement, but only the returns the portfolio generates. Successful interest-only retirement investors may be able to pass the untouched principal to their heirs.
Since you are maintaining principal, you won’t have to watch your retirement savings decline in retirement. “The other main benefits for retirement savers are lower risk and less stress,” says Kevan Melchiorre, managing partner at Tenet Wealth Partners in Champaign, Illinois. “This is because you are generally utilizing securities such as money markets, investment-grade bonds or certificates of deposit to get your yield, which are less volatile than stocks and have a more consistent fixed income stream.” An interest-only retirement plan provides retirees the comfort of knowing they have a very high probability of not running out of money or having to deal with market fluctuations.
How Much Money Do You Need to Live Off Interest?
Knowing how much money you will need to retire is especially important for interest-only retirement plans. “An interest-only retirement plan has sufficient investments to spin off the income needed to meet your ongoing expenses without having to sell any of the principal investments in your portfolio,” says Kevin Swanson, CEO of Potentia Wealth in San Jose, California. “This is different from the 4% rule where retirees can safely withdraw an amount equal to 4% of their investments during the year, adjusted for inflation.”
An interest-only retirement plan typically requires a significant amount of savings. For example, “Let’s say your expenses at retirement are $10,000 a month or $120,000 per year,” Swanson says. “Using a 3% interest rate, we can determine roughly how much in investments we need to support that annual income.” In this scenario, the retiree would need $4 million in total retirement savings to meet the above retirement target.
You will need a large retirement portfolio to be able to cover your expenses with the generated interest. “Using these variables, an investor would expect to receive 3% or $30,000 per year for each million dollars invested,” Swanson says. “As a result, setting up an interest-only retirement plan requires significant planning, as there are numerous factors that can prevent the plan from being successful, including declining interest rates, inflation and unexpected expenses.”
A Interest-Only Retirement Plan Versus the 4% Rule
Interest-only retirement plans aren’t the same as investment plans based on the 4% rule. When an investor uses the 4% rule for taking retirement portfolio distributions, the retiree uses the principal to make distribution payments. “The 4% rule allows the retiree to dip into principal in down markets and is small enough a distribution to allow the retiree’s portfolio to recover in positive markets,” Swanson says. “That’s different than an interest-only retirement plan, where you can’t touch the principal.”
How to Select Interest-Generating Investments
The most common investment vehicles that earn interest include public and private bonds and bond funds, bank savings accounts and real estate investments. In 2022, investors are seeing more robust rates on investment-grade bonds, high-yield savings accounts and certificates of deposit. “For high-yield savings, you can get anywhere from 1% to 1.5% depending on the online bank,” Melchiorre says. “Intermediate investment-grade bonds are yielding anywhere from 2.5% or higher, and 1- to 30-year U.S. Treasuries are all close to 3% right now.”
But interest rates are variable and are not guaranteed to stay the same throughout your retirement. “If an investor is using mutual funds or exchange-traded bond funds, then the interest level is definitely subject to change, which increases the risk of a lower income stream if the interest rate falls,” Melchiorre says. “The same goes for high-yield savings accounts, which were 0.5% or lower when interest rates were near zero.”
How to Build a Laddered Portfolio
If you use an interest-only retirement strategy, aim to diversify income streams to balance out any potential risk of falling interest rates over time. “One strategy that can be employed, especially starting now with interest rates moving higher recently, is building a laddered investment-grade bond portfolio,” Melchiorre says. “Laddering bonds simply means buying high-quality and high-rated U.S. bonds that mature at different times, so some maturing in the next one to three years, others maturing in the next four to seven years.”
Laddering U.S. Treasuries can help you lock in rates of around 3% right now with a high level of safety, since the investor receives the principal back at maturity. “You can also supplement with certificates of deposit if you want FDIC insurance as well as Series I savings bonds currently paying around 9.6%,” Melchiorre says. “Keep in mind that as bonds mature, an investor would need to find a new bond to purchase, and it may be at a lower interest rate depending on where rates are in that year.”
Another investment strategy that involves taking on some market risk or credit risk is investing in dividend-paying stocks or higher-yield asset classes like real estate or high-yield bonds. “Just note that interest rates are still subject to change with those securities, and the value of your investment is likely to fluctuate as well,” Melchiorre says.
How to Tell if an Interest-Only Retirement Plan Is Right For You
Melchiorre doesn’t believe an interest-only strategy is ideal or sustainable unless the retiree has a significant asset base saved. “Inflation adds more fuel to the fire of why this strategy isn’t the most prudent since even modest inflation, which has averaged around 3.25% since 1914, erodes purchasing power over time,” Melchiorre says. “We feel a total return approach, taking into account not just income but also growth, is more ideal, especially when you incorporate multiple streams of income from different sources, like stocks, bonds, real estate and Social Security.”
An interest-rate only retirement plan is feasible, but it also has some drawbacks. “If you’re aware of all the nuances of an interest-only retirement planning strategy and you remain flexible, that strategy can work,” says Rick Nott, a senior wealth advisor at Lourd Murray in Beverly Hills, California. “You need to be OK with having income that is not consistent from month to month, and you need to diversify across many classes of investments and make sure you understand the risks of those investments.”