interest ratesYou are retired and you are currently taking a 4% distribution from your retirement assets to fund your standard of living. You are an old school investor who was taught to spend investment income (dividends, interest), but never your principal. You will never run out of money if you don’t spend your principal.

However, this investment philosophy falls apart when interest rates are less than your distribution rate.

Low Interest Rates 

I won’t bore you with a lot of information about low interest rates. You already know you have a big problem if you are retired, you are taking 4% distributions from your retirement plan, and you are 100% invested in the short-intermediate bond market:

  • 1 Year CD                     1.00%
  • 1 Year Treasury            0.14%
  • 5 Year Treasury            1.39%
  • 10 Year Treasury          2.66%
  • Source:

Retirement Account Deductions 

What you may not know is your problem is actually bigger than the low interest rates shown above. Let’s assume you have all of your retirement assets invested in 10-year treasuries. Your annual return from income is 2.66%. We are not going to assume there is any appreciation or depreciation.

But the 2.66% is your gross return. You have to make a few deductions to determine what I will call your actual rate of return.

  • We know you took 4% out of your retirement account
  • Did you pay an advisor or money manager a fee (0.50%) to make investment decisions for you?
  • You should deduct 2% for the impact of inflation. Why? Inflation impacts the purchasing of your assets. Remember when $4 milk used to be $1. Your annual performance should offset the impact of inflation to protect your purchasing power.
  • Did you pay any transaction charges to buy or sell investments during the year? Let’s assume you paid 0.25%.
  • Did you pay a custodian to hold your assets for you? Or, did you pay an administrative fee or marketing fee? Let’s assume you paid another 0.25%.
  • Your distributions are taxable income so you distributed more than you actually needed to cover the tax bill.

I am sure you can see the writing on the wall. Your total deductions were 7% and your interest income was less than 3%. These numbers are not a big problem for a year or two. But, they are disastrous if you experience a low growth economy and low interest rates for an extended period of time. Japan has had low growth and extremely low interest rates for 20 years – it can happen.

Don’t Invade Your Principal 

Let’s revisit the concept of not invading principal. Let’s suppose you started the year with $1 million that produced your $26,600 of income. However, you need $40,000 to make ends meet and protect your standard of living. Where does the other $13,400 come from? You only have one choice, your principal. You boxed yourself in.

There is an alternative. Assuming you have some tolerance for risk you invest in a diversified portfolio of blue chip stocks and high quality bonds. The portfolio produced an 8% return that year. You covered your 4% distribution and all of the other forms of erosion and had 1% left over for reinvestment. You started the year with $1,000,000 and you ended the year with $1,010,000. Your principal is intact and you have enough left over to spend two weeks in Hawaii playing golf and learning the hula – good exercise.

You actually have $1,030,000 because inflation is not deducted from your assets like expenses. But, it should not be ignored. 2% inflation doesn’t sound like much until you compound it over longer time periods and milk is $8.

The 30 Year Solution

Why does the above scenario work? I wrapped investment income and market appreciation together. Your 8% return was 2.66% from interest and 5.34% from appreciation. You will have to take some risk to achieve this return, but you do not have a lot of choices when interest rates are low and you and your spouse may live another twenty or thirty years.