Increase Retirement Income Using Income Replacement Funds

In an ideal world, a potential early retiree would own an investment portfolio large enough to safely generate more income than necessary to support his desired standard of living, from the start of early retirement to the day he becomes eligible to receive social security and any vested pension benefits. This portfolio would be invested in assets stable enough to protect against market and interest-rate risks, flexible enough to respond to unexpected financial emergencies, and robust enough to offset inflation.

Unfortunately, today’s low-interest rate environment is far from ideal, with this week’s 5-year certificate of deposit (“CD”) interest rates averaging a paltry 1.49% (per www.Bankrate.com). At such low rates, few people can amass sufficient wealth to retire early without taking a great deal of risk. For example, a potential early retiree owning a $500,000 investment portfolio could expect to generate interest income of just $7,450 per year by investing in 5-year CDs. One solution to help fill this early-retirement income gap is for the retiree to invest part of his portfolio in an income replacement fund. This article provides an example of how this strategy can be successfully employed, and also discusses some of the advantages and disadvantages of using income replacement funds to fill this income gap.

Ms. Rose would like to retire from her job as an engineer at a national company to pursue her hobby of raising flowers. Ms. Rose is 59 years old, owns her house (and garden!) outright, and also owns an investment portfolio of $500,000. Her portfolio is invested in a mix of stocks and bonds, and generates interest and dividend income of $20,000 per year (an average of 4%). Ms. Rose has reached her 25^th anniversary at work, and has earned a vested pension of $40,000 per year starting on her 65^th birthday. By analyzing her spending, she has found that she will require a retirement income of $3,000 per month to live comfortably, though this amount will need to increase with inflation. Would it be reasonable for Ms. Rose to retire at age 59, or must she continue working?

Unfortunately, Ms. Rose will be unable to retire at age 59 simply by buying ultra-safe CDs with her investment portfolio. At an interest rate of 1.49%, her $500,000 investment portfolio would generate only $7,450 per year, or only $621 per month. This would fall far short of the $3,000 per month Ms. Rose will need in retirement. While the value of the CDs would be protected against market risk, Ms. Rose would have little flexibility in dealing with unexpected financial emergencies (e.g., the need for a new roof), and the effective purchasing power of the CDs would decline each year due to inflation. Thus, buying CDs would be a poor strategy for enabling Ms. Rose to reach her goal of early retirement.

Keeping Ms. Rose’s investment portfolio in its current mix of stocks and bonds would also be a poor strategy. As noted earlier, this portfolio is currently generating an annual income of $20,000, which is only $1,667 per month. This would again fall short of the $3,000 per month that Ms. Rose will need. In comparison to the strategy of buying a CD portfolio, this stocks-and-bonds strategy would be more susceptible to market risk, though it would give Ms. Rose more flexibility to deal with unexpected financial issues, and would also be more likely to provide some measure of inflation protection.

A better strategy would involve Ms. Rose investing a portion of her portfolio in an income replacement fund, while keeping the remainder in stocks and bonds. For example, assume Ms. Rose were to invest $150,000 in the Fidelity Income Replacement 2018 fund (ticker symbol “FIRKX”) while keeping the remaining $350,000 in her current mix of stocks and bonds. Ms. Rose would receive current year monthly payments of $1,906 from the FIRKX investment (per the calculator at www.Fidelity.com on 23 February 2012), plus $1,167 monthly from her stocks and bonds ($350,000 at 4%). Thus, Ms. Rose would receive a total of $3,073 per month, more than covering her needs of $3,000 per month. These payments would continue until Ms. Rose reaches her normal retirement age of 65, with the payments from the FIRKX investment likely to increase at the rate of inflation. Once Ms. Rose reaches age 65, the payments from the income replacement fund would be exhausted but would be replaced by her vested pension of $40,000 per year. Along with her pension, Ms. Rose would receive the $14,000 per year from her stocks and bonds plus her social security payments.

By using this strategy of investing a portion of her portfolio in an income replacement fund while keeping the remainder in a mix of stocks and bonds, Ms. Rose would maintain flexibility in dealing with unexpected financial emergencies both because her stocks and bonds would be liquid assets and also because she would be free to sell all or some of her income replacement fund to raise cash. This strategy would also provide inflation protection both because the value of her stocks would likely rise during her years of early retirement, and also because the payments from the income replacement fund are designed to increase each year.

As with any investment, this strategy carries risks and drawbacks. One risk is that the value of the income replacement fund—and its monthly payments--could fall with a falling market. This market risk could also impact the value and income of the remainder of the portfolio that’s in stocks and bonds. One drawback is that the income replacement fund itself will, by design, be completely depleted by the time Ms. Rose turns 65, and will not be available to cover further retirement expenses after that point. Thus, this strategy would not be appropriate for people without sufficient alternative retirement assets.