May 26, 2019
For an interest-only retirement, you’ll need to have a large nest egg. How big a nest egg depends on your target income and the interest rate. For example, an annual income of $48,000 would require a nest egg of $1.6 million, assuming a 3% interest rate. And that’s not even accounting for inflation. To make sure you have enough income when you retire, consider consulting a financial advisor. In the meantime, here’s what you need to know about living off interest during retirement.
When you’re doing the math for retirement, planning to live off the interest makes for the simplest calculation. After all, it takes the greatest unknown – how many years you’ll live – out of the equation. You’ll just earn X amount every year, leaving the principal untouched, and when you die, you’ll pass on your nest egg to your heirs.
This is a good starting point for calculating your retirement needs, and we’ll show you how to do the math for yourself. But you probably don’t want to plan on living off just the interest. We’ll explain why and suggest other ways of living off your savings.
Figuring out How Much You Need to Save to Live off the Interest Alone
To reverse engineer the size of your nest egg, start by deciding how much income you think you’ll need. Many people expect their expenses to drop when they retire, since they won’t have to commute, buy lunch by the office, pay for regular dry cleaning, etc. But other costs – like travel and entertainment – can offset the savings. So as a general rule, experts recommend counting on needing 70% to 90% of your current expenses.
Next, you need to choose an interest rate. Banks have paid under 1% in recent years, while they used to pay in the high single digits in the early 1990s. If you want to be conservative, you could go with 1% to 3%. If you are feeling more optimistic, you could choose 6% to 8%.
Now take your expected annual income and divide it by the interest rate. For example, if you think you’ll need $60,000 a year (or $5,000 monthly) and chose an optimistic 6%, you would divide 60,000 by .06. The result is your savings goal. In this case: $1,000,000.
For a more conservative estimate, though, divide 60,000 by 3%. That gives you a savings goal of $2,000,000. If you use an even more conservative (and realistic for savings accounts these days) interest rate of 1%, you would need $6,000,000 to earn $60,000 a year in interest.
Living off Interest Alone Isn’t a Practical Plan
Of course, for most people, a $6,000,000 nest egg isn’t within the realm of possibility. Even accumulating $1,000,000 is out of the reach of the majority of Americans. According to the TransAmerica Center for Retirement Studies, baby boomers (the generation closest to retirement if not in it already), have a median $152,000 in retirement accounts.
Feasibility aside, living off the interest of your savings is a bad plan for two big reasons. First, inflation will likely depress the purchasing power of your income. So the $60,000 you think you’ll need in 30 years will actually be worth $28,600 in today’s dollars, assuming a 2.5% rate of inflation. (The Federal Reserve aims for an inflation rate between 2% and 3%.) To have $60,000 in today’s dollars in 30 years, you would need to aim for an annual income of $125,900. That would reset your savings goal to $2.1 million, assuming an optimistic 6% interest rate.
Second, the calculation assumes a steady interest rate over the span of 25 or so years. In reality, interest rates fluctuate. Between January 1991 and January 2016, a 5-year certificate of deposit (CD) that was rolled over every time it matured could have earned 7.67%, 5.28%, 5.58%, 3.92%, 1.57% and 0.86% (that is less than 1%). When the interest rate is higher than you expected, you’ll have extra cash. But the years the interest rate is lower, you’ll probably dip into savings. And if you touch the nest egg, you will lower the amount you earn every year thereafter.
Finding Better Sources of Income
Even if you have a low tolerance for risk and want safe investments, you can fund your retirement with more than the variable interest earned from a bank. First, there are annuities, which provide protected income. There are many kinds of annuities, but with the simplest kind, a fixed annuity, you pay a lump sum and in return you get a set payout every year for the rest of your life. Often, the rate is better than the ones banks offer. But the tradeoff may be that the insurance company keeps whatever principal is left when you die.
Alternately, if you’ve been growing your savings by investing it in the stock market with the help of a fiduciary financial advisor, you could leave it there. Probably, as you approach retirement, you’ll want to bring down the percentage in equities while raising the percentage in fixed income (bonds). This is to help ensure that the bulk of your investments isn’t in jeopardy should the market take a nosedive when you need to make withdrawals. Traditionally, the rule of thumb for calculating how much to be in stocks has been to subtract your age from 100. That number is the percentage you should allocate to stocks. But in recent years, experts have amended the rule to subtracting your age from 125.
The Bottom Line
Calculating how much you need to save to be able to live off the interest alone in retirement is a good jumping off point. It is easy to compute, and it gives you a sense of the large sum of money you’ll need for retirement. But once you have that number, you should consider ways other than interest to fund your golden years. With higher returns, you’re more likely to be able to maintain your lifestyle. As you come up with an effective strategy to be financially ready for your golden years, be sure to consult with a financial planner or financial advisor.
Tips for Saving Enough for Retirement
– Increase your savings rate every time you get a raise. The funny thing about expenses is that they often go up with income. So if you bump up your savings rate as soon as you get a raise, you won’t have the chance to increase your expenses and you won’t miss the increased pay that is going straight to savings.
– Be as aggressive an investor as you’re comfortable with. Historically, the stock market has offered the best return on investments. But that comes with increased risk. To maximize your money’s potential for growth without fear, consider turning to an expert whose business is understanding the markets. To find the best one near you, use SmartAsset’s financial advisor matching tool. You just have to answer a few questions about your zip code and financial goals.
Sources: SmartAsset Blog and Yahoo! Finance