Generating income in early retirement

One of the two major concerns for early retirees is how to generate enough income to live on until you are eligible to receive retirement income such as social security, pension or 401(k)/IRA distributions (The other major concern is health insurance, which I will cover in a separate post).
As I show in my earlier posts on our Net worth, most of our savings are in tax-deferred retirement accounts. This is intentional, since we want to contribute as much as we can to tax-deferred accounts, to take advantage of the tax deferred growth and the tax deductions where possible. But this causes a problem: if we want to retire early, say at age 50, we have to have enough money in taxable accounts to live for at least 9.5 years, until we become eligible to take distributions from 401(k) and IRA accounts at age 59 1/2.
As I mentioned in an earlier post, it is possible to make early withdrawals from retirement accounts without penalty. But clearly this is something you want to avoid, unless you really have to. Making withdrawals from retirement accounts reduces the tax-deferred growth potential of assets held in these accounts. During early retirement years, I would like to think of money in retirement accounts as a safety net that we would rather not have to depend on. It would be preferable to have enough money in taxable accounts to cover these early retirement years.
So what is the best way to invest money in your taxable accounts so as to generate enough income during early retirement?
Clearly, you want to use only relatively safe investments, since this is money that you would need in the short term. You can be aggressive with investments in retirement accounts, but stick to more conservative options for money earmarked for early retirement.
Also, it pays to minimize your expenses during early retirement years, so that you can keep your withdrawals to a minimum. These are the best years to consider moving to a low-cost country, for instance. You may be able to keep your income low enough that you pay little or no taxes. As I explained in an older post on our financial goals for retirement, a modest $300K in taxable accounts could generate $1000/month, which may pay for a decent living in many parts of the world. These years could also be a good time to consider converting your tax-deferred accounts to Roth IRAs to minimize future tax liability.
What are some specific investment options for money in taxable accounts intended for early retirement?

  • Bank CDs are simple and safe. 10-year CDs are currently available at 5.35% interest. With $300K of principal, this yields about $1338 per month. FDIC insurance covers only $100K per account, so it may make sense to hold them at different institutions.
  • Treasury bonds are the safest investments of all. 10-year treasury notes currently yield 3.875% and 10-year treasury inflation-indexed notes (TIPS) 1.625% over inflation.
  • A common approach to holding CDs and bonds is to ladder them, where you hold a portfolio of CDs or bonds with different maturities. This reduces risk, and frees up money for spending as you need them.
  • A popular strategy for allocating money in retirement is the buckets of money approach where you preallocate money into different buckets depending when you intend to use them, and invest them accordingly.
  • Immediate annuities (such as the Vanguard Lifetime Income program) have traditionally been used to generate guaranteed lifetime income for retirees, but most early retirees may be too young to gain much from these.
  • Mutual funds that generate income, such as bond funds and some balanced funds, are sometimes recommended for retirees who need income. These are riskier, since it is possible to lose your principal, and your income may vary considerably. A popular option is the Vanguard Wellesley Income fund (VWINX), which holds 60% bonds and 40% equities.
  • Recently, some fund companies have introduced funds specifically intended for income generation. These are relatively new, and they may be intended for retirement accounts, but they appear to be suited for early retirees as well. I will mention two of these below.
  • Vanguard Managed Payout funds are intended to preserve the initial investment and make monthly payouts. This is a perpetual investment with no preset maturity, and the investor may make new deposits or withdraw capital (in part or full) at anytime. The fund plans to pay 7% per year interest, and it currently pays $1,751 per month for the year 2008 for an investment of $300K. Payout rates are fixed for a calendar year and then updated based on fund performance over the previous three years. Rates are not guaranteed; they can go up or down.
  • Fidelity Income Replacement Funds use part of the invested capital for making the monthly payouts. As a result, the capital is not preserved and it goes to zero at maturity. According to the website, a $300,000 investment for 10 years pays $2,739 per month in year 2008. These payouts are so attractive because of the depreciation of the initial capital.

Related posts:

Related links:
  • Discussion from Fatwallet forum on Regular Monthly Income by Investing Savings
  • Morningstar article on Vanguard managed payout funds