As retirement options go, what is often presented as ideal is interest-only income. In ꧙theory, it seems simple. You invest your savings in interest-bearing assets. Whatever interest you earn is the money you spend in your retirement 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 澳洲幸运5官方开奖结果体彩网:Social Security and a pension if you're luc♉ky. When you die, your surviving spouse or heirs receiveꦓ 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 smღart moves to get past them.

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 entiret🍷y 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.

When Interest-Only Works

An interest-only strategy can work for those who possess 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.

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-i💦ncome securities𝔉 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 at several types of bonds such as agency, corporate, and even foreign bonds.

Ultimately, investors need to be aware of the risks inherent with each type of bond, including default risk, 澳洲幸运5官方开奖结果体彩网:interest rate risk, inflationary risk, event risk, and the risk of large price fluctuations. You can even lose money with a Treasury bo🍸nd 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 澳洲幸运5官方开奖结果体彩网:laddering. The strategy helps to h📖edge 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 澳洲幸运5官方开奖结果体彩网:liquidate your mutual fund shares, which is akin to a 澳洲幸运5官方开奖结果体彩网: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 do💜esn't provide the same benefits.

Deferred Annuities

Another useful tool is the fixed 澳洲幸运5官方开奖结果体彩网: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.

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 the safety of the principal. Immediate annuities use up the principal while 澳洲幸运5官方开奖结果体彩网:variable annuities, l🐟ike mutual funds, can decline (or increase) in value.

Each type has its place, but for an interest-only strategy, a fixed def👍erred🌃 annuity is preferred. 

The Hidden Problem: Inflation

From 1983 to 2023, inflation has ranged from 1.3% to as much as 2022's 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 di🐻d in the iꩲnitial 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 retire🐲ment years.

This is a big strike against the interest-only strategy. A portfolio of fixed-income securities offers little to no protection against inflation, except for 澳洲幸运5官方开奖结果体彩网:Treasury Infla🧸tion-Protected S🦩ecurities (TIPS).

This is also why yo♔u really need excess savings to do a🍎n 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 possibiliti🐷es. 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.