An interest-only pension plan aims to create a long-term investment portfolio that allows savers to live off the interest earned on their investments and leave the capital of the portfolio intact. Once the portfolio owner retires, the retiree should be able to live off the interest earned on the investments without having to touch the capital of the portfolio.
With an interest-only pension plan:
- You live off the interest earned on interest-bearing investments.
- You need to figure out how much to save so you can live off the interest earned.
- Consider inflation and potential bear markets in any interest-only planning equation.
- Bond laddering can be an effective way to achieve a secure, interest-only retirement outcome.
What is an interest-only pension plan?
An interest-only retirement planning strategy involves investing in financial assets such as dividend-paying stocks, bonds, and funds over a long period of time. The retiree does not spend the capital of the portfolio in retirement, only the returns generated by the portfolio. Successful interest-only retirement investors may be able to pass the principal intact to their heirs.
Since you’re maintaining the capital, you won’t have to see your retirement savings dwindle in retirement. “The other major benefits for retirement savers are lower risk and less stress,” says Kevan Melchiorre, managing partner at Tenet Wealth Partners in Champaign, Illinois. “That’s because you typically use securities such as money markets, investment grade bonds, or certificates of deposit to get your return, which are less volatile than stocks and have a more consistent stream of fixed income.” An interest-only pension plan gives retirees the comfort of knowing that 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 on interest?
Knowing how much money you will need in retirement is especially important for interest-only pension plans. “An interest-only retirement plan has enough investments to generate the income needed to meet your current expenses without having to sell one of the major investments in your portfolio,” says Kevin Swanson, CEO of Potentia Wealth in San Joseph, 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 pension plan generally requires significant savings. For example, “Let’s say your expenses in retirement are $10,000 a month or $120,000 a year,” says Swanson. “Using a 3% interest rate, we can roughly determine the amount of investment we need to support this annual income.” In this scenario, the retiree would need $4 million in total retirement savings to meet the above retirement goal.
You will need a large retirement portfolio to be able to cover your expenses with the interest generated. “Using these variables, an investor would expect to receive 3% or $30,000 per year for every million dollars invested,” says Swanson. “Therefore, setting up an interest-only pension plan requires significant planning, as many factors can prevent the plan’s success, including falling interest rates, inflation, and unforeseen expenses. “
An interest-only pension plan versus the 4% rule
Interest-only pension plans are not the same as investment plans based on the 4% rule. When an investor uses the 4% rule to make distributions from the retirement portfolio, the retiree uses the principal to make the distribution payments. “The 4% rule allows the retiree to draw in principal in down markets and is a small enough distribution to allow the retiree’s portfolio to recover in positive markets,” Swanson said. “It’s different from an interest-only pension plan, where you can’t touch the capital.”
How to select interest-bearing investments
The most common investment vehicles that earn interest are 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 between 1% and 1.5% depending on the online bank,” Melchiorre says. “Intermediate investment grade bonds are yielding 2.5% or more, and 1-30 year US 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 uses mutual funds or exchange-traded bond funds, the level of interest is definitely subject to change, which increases the risk of a decline in the flow of income if the interest rate falls” , says Melchiorre. “The same goes for high-yield savings accounts, which were 0.5% or lower when interest rates were close to zero.”
How to Build a Laddered Portfolio
If you are using an interest-only retirement strategy, try to diversify income streams to offset any potential risk of declining interest rates over time. “One strategy that can be employed, especially going forward with the recent rise in interest rates, is to build a portfolio of higher quality laddered bonds,” Melchiorre said. “Bond laddering simply means buying high-quality, well-rated U.S. bonds that mature at different times, so some mature in one to three years, others in four to next seven years.”
Laddering US Treasuries can help you lock in rates around 3% now with a high level of security, since the investor gets 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 which currently pay around 9.6%,” Melchiorre says. “Keep in mind that as bonds mature, an investor should find a new bond to buy, and it may be at a lower interest rate depending on the rate situation that year. “
Another investment strategy that involves taking on some market or credit risk is to invest in dividend paying stocks or higher yielding asset classes like real estate or high yield bonds. “Just note that interest rates are always subject to change with these securities and the value of your investment is also subject to fluctuation,” says Melchiorre.
How to know if an interest-only pension plan is right for you
Melchiorre does not believe that an interest-only strategy is ideal or sustainable unless the retiree has a large saved asset base. “Inflation adds more fuel to the fire to explain why this strategy is not the most prudent since even modest inflation, averaging around 3.25% since 1914, erodes purchasing power over time. “, says Melchiorre. “We believe that a total return approach, considering not just revenue but also growth, is more ideal, especially when you incorporate multiple streams of income from different sources, such as stocks, bonds, real estate and social security.
An interest-only pension plan is feasible, but it also has some drawbacks. “If you know all the nuances of an interest-only retirement planning strategy and stay flexible, this strategy can work,” says Rick Nott, senior wealth management advisor at Lourd Murray in Beverly Hills, in California. “You have to accept having an income that is not constant from month to month, and you have to diversify into many categories of investments and make sure you understand the risks of those investments.”