A reader writes: Now that bonds are yielding over 5%, can I fund my retirement just from the interest?

This is a great question that goes to the heart of retirement planning strategies. The first requirement is that you have managed to save enough money. If you expect to spend $100K per year in retirement, and fixed income investments are returning 5% annually, you’ll need $2 million for the duration of your retirement. Do you have that much?

Assuming that you are a multi-millionaire, what assurance do you have that bonds and CDs will continue provide you with the needed return? I recall meeting a retired college CFO at a wedding in Maryland around twenty years ago. He told me he kept most of his savings in safe muni bonds and lived off the interest (which at the time generated about a 5% return). He also said he and his wife didn’t travel much and spent most of their time gardening and reading. I recall thinking at the time that such a strategy might work for such a frugal lifestyle. But five years later the 2008 recession hit. Munis in particular – previously insured against municipal bankruptcies for safety – dropped in value as their ratings collapsed and insurers fled. Since 2014 munis had been yielding less than 4% and by 2020 as little as 2%. Plus their safety has dropped considerably. From time to time I think about that retired CFO and wonder how well his retirement strategy had ultimately worked out for him.

There are, of course, many other types of fixed income securities available for investment if munis are not viable for your risk/return profile. You could choose from U.S. treasuries, corporates, mortgage-backed securities (MBS), high-yield and variable-rate securities, not to mention foreign sovereign bonds. But each may perform differently depending on the economic environment. Which one(s) will provide you with the return you need in a consistent manner from year to year?

Which brings up the impact that inflation can have on fixed income investments. Hardly anyone paid attention to it throughout the 2010 decade. But everybody worries about it now. Think about this: just a 4% annual inflation rate would cut the purchasing power of your savings in half after 18 years. At that point you’re statistically only a bit more than halfway through a thirty-year retirement beginning at age 65. The greater your longevity the less likely bonds and particularly cash will maintain inflation-adjusted income.

In my experience a total-return approach to retirement is a more secure way to maximize the likelihood that you won’t run out of money in retirement. Such a strategy involves investing in a more diversified set of securities, for example stocks as well as bonds. Annual income is based on interest and dividends as well as on periodic sales of assets. There are several benefits to this approach.

First, portfolio diversification (and therefore risk) is improved by including more types of assets that are less correlated with each other. Plus you get the boost in growth from stocks that bonds or cash are very unlikely to provide over time. Second, this approach enables more control over the size and timing of portfolio withdrawals. That‘s beneficial since spending on things like travel, vehicles, and even healthcare often varies from one year to the next. And by controlling the timing you can additionally improve tax efficiency.

If you can afford to support yourself in retirement solely based on the interest from fixed income investments, by all means do so. The good news is that there’s a viable alternative for those of us who are less fortunate.