As people enter retirement, one of their greatest concerns is that they could run out of money in their old age.

The method that some people attempt to use as a means of protection from this fear is to look for the highest rate of return they can find in something “safe”, like a CD or other fixed-interest rate investment, and try to live purely off the yearly interest they earn.

They reason that this could potentially solve their need for income without ever having to dig into their principal balance.

For a simple example, let’s say that Robert, age 62, has $300,000 in savings, and he has been able to invest in a bond or CD that is paying a 3% rate of return. This means that Robert’s CD would generate $9,000 per year or $750 per month of interest income ($3 00,000 x .09 = $9,000), without causing Robert to dip into his $300,000 principal.

Now, this strategy can certainly work, and has done so for many people. However, especially in light of the current low interest rate environment, many retirees have been experiencing more and more challenges and frustrations when it comes to meeting their ongoing needs with this type of an approach.

Let’s look now at the main problems that can occur with this option:

Problem #1 – Finding A Competitive Interest Rate

If someone is living on an income stream that is derived purely from the rate of return that they are earning, doesn’t that mean that they are basically a slave to whatever the current interest rate environment is at that time? Absolutely!

At the time this article is being written, we have seen a dramatic decline in interest rates on bonds and CD’s in recent years, and many retirees who were used to getting 4% or better in their fixed interest rate accounts are now having to renew at less than 2%.

If Robert, our retiree from the example above, was used to getting a 4% return on his $300,000 of principal, but now is only able to find a 2% return as a renewal rate, he has just experienced a 50% LOSS of his monthly income ($300,000 @ 4% produces $1,000 per month of income, but $300,000 @ 2% only produces $500 per month of income).

This is why so many retirees who are dependent on the interest income from their fixed-rate investments are having such a hard time.

How does one combat this problem? They either have to go out and find a higher rate of return, which as we have already discussed may not even be available, at least not at an acceptable level of risk – or they have to start withdrawing principal and interest at the same time, which now adds to the original fear they were first trying to avoid - the fear of running out of money.

Problem #2 – Living Off Interest Only = No Compound Interest

Compound interest is the simple, but powerful mathematical process of interest earning interest on itself over the years, giving the owner a snowballing-type of effect on the growth of their money.

Albert Einstein once said that compound interest was the eighth wonder of the world. Why would he say that?

Well, suppose that Christopher Columbus had deposited $100 into two separate bank accounts immediately upon his arrival (don’t ask us why there was a bank conveniently on the shores of the New World already waiting for him, but we’re pretty sure it would have been named “First National Bank”).

The first account paid 10% simple interest (that means interest only on the principal each year) and the other account paid 5% compounding interest (interest on the principal and previous interest earned). How much money do you think each account would be worth today?

Give up? 518 years later, the 10% simple interest account would have a balance of $5,250. The account with 5% compound interest would be worth over $8.61 trillion! Granted, we know that most folks are probably not going to have a 500-year retirement, but nonetheless, it is a very interesting example that illustrates the power of compound interest.

So what does all this have to do with living off bond or CD interest? Well, if you are living off your interest, then by definition doesn’t that mean you are withdrawing all of your growth as so on as it’s being earned?

And if you are withdrawing your growth as soon as it’s being earned, is your principal balance enjoying any compound interest? No, it’s not, which means that you could be missing out of one of the most powerful of all mathematical laws, by not making sure that it is working in your favor!

Now, if you’re asking yourself yet, “Okay, so how do I fix this and what do you propose is better”? Just know that we are going to be offering some very simple and helpful solutions to all these challenges in the next several lessons that you will be receiving.

But for now, let’s move on and explore the next common way that people generate income during retirement and the challenges it creates.

Option #2 - Purchasing An Annuity With A Guaranteed Income Payout

An immediate fixed annuity is a contract between you and an insurance company stating that you will give them a certain sum of money (principal) and in return they will guarantee to pay you monthly amounts (income) for a certain number of years (10,15, or 20, etc.) or for your lifetime, depending on which payout option that you choose.

Since the time of the Romans, when annuities were first invented to pay the retirement salaries of retiring senators, to the present, people have been relying on annuities to provide systematic, safe, and predictable income to help meet their needs during retirement.

These types of financial vehicles can be a tremendous benefit when applied correctly and have helped meet the income needs of countless retirees over the centuries. However, they too come with some specific disadvantages that are being magnified even more now, due to the current negative economy.

Problem #1 – Irreversible Decision

When you purchase an immediate income annuity from an insurance company, what you are effectively doing is signing over ownership of your principal in an irreversible or irrevocable manner.

Let’s check back in with Robert, our fictitious retiree we met earlier in this article. You may recall that Robert had $300,000 in savings, and after learning about the limitations that come with living off his interest from CD’s, he wonders now if an immediate income annuity might be a better option.

If Robert were to use his $300,000 to purchase a fixed annuity, he would receive guaranteed monthly income payments of $1,800 per month for the rest of his life, which is certainly a higher guaranteed income stream than his CD’s were paying.

However, upon signing the annuity contract, he no longer is able to maintain ownership of his $300,000 principal. This means that 5 years from now, if he has an emergency and needs to access $40,000 quickly, he is not able to do so, even for a large surrender charge. The money literally does not belong to him anymore. He would still continue receiving his scheduled $1,800 per month of income, but he can never again access his principal for any reason or for any amount of penalty. It is simply no longer his.

Problem #2 – No Preservation or Recovery of Principal

We just discussed how Robert’s ownership of his principal has been forfeited, but it is important to understand that this also means there is no preservation or recovery of principal “at the other end” for his spouse or his children.

Had Robert selected a 20 year income stream instead of a lifetime income, the insurance company would have simply paid out his entire original principal of $300,000 with some minimal interest over a 20 year period; but at the other end, the contract would have expired, the income payments would shut off, and there would be nothing else left over.

Problem #3 – No Inflation Protection

While there are some exceptions out there, the vast majority of immediate annuities purchased in the United States offer no inflation adjustments to your income stream. This means that Robert will be receiving the same $1,800 at age 80 that he was receiving at age 62, even though the prices of the everyday goods that he purchases could have potentially doubled in the same time frame.

Therefore, in conclusion of this option, we see that while annuities can offer certain desirable benefits such as safety and guarantees, they are also a prime example of the “tradeoffs” that you are forced into making with this type of conventional approach. Most retirees want income, growth, and preservation of principal all at the same time, not one at the sacrifice of others.

Let’s now look at the third common way that people attempt to create income…

Option #3 – Systematic Withdrawals From A Non-Guaranteed Portfolio

OK, so at this point Robert is not feeling very confident about his needs being met adequately through bond/CD interest, or from an immediate annuity.

He wonders if maybe a “professionally managed diversified portfolio” would be a better option.

Perhaps he could earn enough interest each year to preserve his principal while still making consistent withdrawals each year for income purposes.

Well…perhaps!

Let’s first take a quick look at some basic rules of financial planning; then, we will look at the main problems and frustrations that can come about from this type of option.

Financially speaking, there are 3 primary phases in someone’s life:

Phase #1 – The Accumulation Phase

Phase #2 – The Transition Phase

Phase #3 – The Income and Preservation Phase

These phases are represented by the 3 graphics below.