Funding your retirement with investment income has traditionally been thought of as a very conservative way to manage savings. Unfortunately, today's low-interest-rate environment may make the goal of paying for retirement out of income alone unattainable for many people, and in any case it may not be as safe an approach as people think.
Circumstances today call for a more flexible approach to funding retirement. Here are five things you should know about trying to live off investment income.
1. Living off income is not as stable as it sounds
The notion is that if you only spend the income your savings and investments produce, you'll never tap into principal and thus you won't draw down your portfolio. Also, since it is the principal value that is subject to market fluctuations, relying on income from year to year should shelter you from the effects of those fluctuations. That's true, but the income component of a portfolio can be every bit as variable as the principal.
Consider this example: At the beginning of 1980, six-month CD rates were producing over $13,000 in annual income on a $100,000 investment. By the beginning of 2000, this was down to just over $6,000. Today, it would be less than $400. That's a drastic change in financial circumstances, without any fluctuation in principal.
2. Inflation is the enemy of income
Even if CDs were still producing $13,000 a year on a $100,000 investment, that $13,000 would buy a great deal less today than it would have in 1980. In other words, stability isn't enough for a retirement portfolio -- it needs to have some way to grow along with inflation.
3. Don't ignore dividends as a source of income
Savings accounts, money market accounts, CDs and bonds are the type of things that have traditionally dominated income-producing portfolios, but these days dividend yields on stocks are likely to be higher than bank rates, and even competitive with many bond rates.
4. The sustainability principle is sound
While drawing from income alone is a flawed long-term strategy, there is an element of it that represents a sound principle: It is a strategy designed to ensure that a portfolio lasts throughout retirement, since the principal of the account is never invaded. With savings account rates and other income yields so low these days, it may not be realistic to expect to save enough to set up a portfolio that could fund retirement spending in perpetuity, but you should shoot for a portfolio that is designed to outlive your retirement years, even assuming a long lifespan.
5. Drawing on growth and income can allow you to diversify more
The alternative to relying on income alone is to set a moderate withdrawal target -- say 3 to 4 percent -- that you can take from a combination of growth and income. You won't necessarily earn that much every year, but if you keep your withdrawal rate moderate, you should earn enough over time to sustain the portfolio plus have some growth left over to counteract inflation.
The steep drop in interest rates over the past few years shows that risk can come in a variety of different forms. The more you know about the risk of relying on income, the better you'll be able to manage that risk.