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 with a financial advisor.
Figuring Out How Much You Need to Save to Live Off the Interest Alone
When doing the math for retirement, interest-only retirement is an ideal strategy where you invest your savings in assets that pay you interest and you live off that money after retiring without touching the principal balance.
This means that you will have to figure out where your retirement income will come from and how much of your golden age lifestyle it could maintain. But since you do not spend the principal, you could pass this nest egg on to your heirs when you die.
Interest-only retirement is a good starting point for calculating your retirement goals and needs. 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.
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 for 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 will have 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 a more conservative interest rate of 1% (which is more realistic for savings accounts these days), you would need $6,000,000 to earn $60,000 a year in interest.
Why 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%. But it’s worth noting that consumer goods and services increased 5.4% during the 12-month period ending in July 2021.) 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.
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.
Savings Tips to Boost Your Retirement
- Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- 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.
Photo credits: ©iStock.com/UygarGeographic, ©iStock.com/DaLiu and ©iStock.com/Cecille_Areurs