For single-digit millionaires, one of the most widely advised retirement strategies is the “interest-only” approach. The concept is simple enough: you only spend the interest (or the returns) on your various bonds or savings deposits – you never actually diminish the principal that earns the interest. As always though, the devil is in the details:
A simple explanation of interest-only retirement
The strategy is much more complex than this example, but we’re over-simplifying a bit to explain the concept:
Say you have $1 million, in various investments that pay out a yield of around five per cent per year. This would mean an income of around $50,000 a year, for so long as the yield remains the same, and you don’t touch the principal (i.e., you don’t touch the initial $1 million).
Ideally, the yield from your investment portfolio will go on and on until the end of your life, providing income in perpetuity.
How much of a yield do you need to earn? Well as a loose rule of thumb, you can use this formula: (Desired annual income) / (Amount available to invest) x 100.
For example:
Say you want an annual income of $60,000 per year, and have a total of $2 million to invest. You would then target a yield of ($60,000) / ($2 million) = 0.03, or three per cent.
This mean that, the less you have to invest and the higher your desired income, the higher your target yield must be.
Bear in mind this is a very simplified description though, and you should speak to a qualified financial expert for your specific case. Not everyone has the same target retirement income or capital, so the approach can vary.
What can go wrong with an interest-only retirement strategy (and how to deal with it):
- Inflation rate risk is ever-present
- Not all financial products have consistent yields
- Managing the portfolio can get complicated
- Emotions can derail the overall strategy
1. Inflation rate risk is ever-present
Inflation refers to the rate at which the overall cost of goods increases. In most developed countries like Singapore, governments like to target an inflation rate of about three per cent.
Consider that, if you have a yield of three per cent, but the prices of goods are rising at three per cent, you’re effectively getting zero returns. This is even worse if the inflation rate goes above three per cent, and stays there for long periods (e.g., if inflation is at five per cent and your yields are three per cent or below, this is a net negative two per cent; and your portfolio is ultimately being eroded).
This is why sticking to ultra-safe, low-yield investments carries a hidden risk. Consider, for example, a perpetual income bond purchased back in the 1980’s, that pays out a fixed $500 a year.
$500 worth of, say, food in 1980 would cost around $1,095 in the year 2022 (according to the MAS inflation calculator). But assuming your perpetual income bond is still around today, it’s still only producing $500 a year.
To deal with inflation, your portfolio should ideally target a rate that’s at least two per cent above the historical inflation rate (about five per cent at least, in many developed countries).
Ongoing management is also a factor, as you may need to start targeting higher yields during periods of high inflation. Some investments do this better than others.
For example, if you generate income through rent, you could plausibly raise your rental rates as the cost-of-living increases. You cannot, however, increase the coupon rate of a vanilla bond (although you can sell it).
2. Not all financial products have consistent yields
In general, only low-risk, low-yielding investments have very consistent yields. A vanilla fixed-deposit product, for instance, may have an interest rate that doesn’t change all the way till maturity.
(While CPF is often regarded as fixed interest, this is technically wrong. Our CPF rate rarely changes – but the rate is revised on a quarterly basis, and can be changed).
Higher-yielding investments, such as Emerging Market bonds, or flat-out running a business, involve a greater amount of risk. This isn’t as big an issue when you’re younger and still working – but it is a problem if you’re retired, and cannot easily recover from failed investments.
The general solution here is to build a diverse, well-balanced portfolio. This means you have some investments that are low-risk and consistent, and some others that are high-risk, but have higher yields.
By also investing in lowly-correlated (i.e., unrelated) products), you also ensure that a downturn in one market doesn’t impact your entire portfolio.
3. Managing the portfolio can get complicated
Many years ago, around the1970’s by our reckoning, a single-digit millionaire had it easy. They could simply leave their money with a bank, and earn sky-high interest rates the likes of which we never see today.
Back in the ‘70s, if you had a million dollars, banks would pay you interest rates as high as seven per cent or more just to leave it with them.
But as we’ve mentioned in point 2, those days are long gone. These days, you need a mix of different assets in a portfolio. On top of that, you need to know basic strategies like laddering.
This means buying a range of fixed-income products with different maturity dates, to ensure consistent cash flow and re-investment.
For example, you might “ladder” your fixed deposit to mature in 2020, at which point you keep some money, and reinvest it in something that will mature in 2025. In 2021, you have another maturing product that you re-invest in something that matures in 2026, and so forth.
Depending on the kind of yields you need, and your risk appetite, this can all become a very complex process. This is where a financial professional comes in handy, as building the portfolio isn’t a one-time process.
4. Emotions can derail the overall strategy
This is one of the most common reasons the strategy fails. Consider living on $40,000 a year, while you know you have $1 million that you can reach out and grab any time.
Then consider also the impact of age: as we grow older, we begin to wonder if it’s worth hoarding that $1 million and depriving ourselves as time runs short. Quite often, the answer is no. Older investors often break with the strategy, and end-up splurging rather than sticking strictly to the designated income.
This is when they end up spending the principal, to help the children to buy a house, pay for a child’s wedding, fund a grandchild’s University education, etc.
The simple way around this is to automate the process, or have a third-party involved. For example, leave the portfolio untouched and in the hands of an algorithm or financial manager, so your single-digit million is out of sight and out of mind.
A DIY approach is tough for an interest-only strategy
We wish it were as simple as in the old days, but financial markets – as well as wider economies – have grown more complex. It’s sometimes better to have passive or managed finances, perhaps for just a part of your portfolio, so you can stay at your sleeping point.
To find out more about this, do reach out to us at Single Digit Millionaire, so we can refer you to the right experts.
