Multiple Sources of Income to Retire Early

Financial planners often talk about the “three-legged stool” needed for retirement. This term refers to the three sources of income usually relied on by retirees: Social Security; pensions; and personal savings. These income sources are unavailable to early retirees, who are too young to qualify for Social Security or pension payments. However, it’s still possible for early retirees to build a three-legged income stool to support their early retirement. The legs of this stool are just different from those of a normal retiree.

An early retiree needs to build a more-creative income stool supported by legs that depend on his or her personal situation. The purpose of this stool is to generate enough income to support the early retiree during the gap years between the end of his professional career and his normal retirement age. Once the early retiree reaches his normal retirement age, he can depend on the traditional three-legged income stool as he becomes eligible to receive Social Security and pension benefits. Thus, unlike the traditional three-legged income stool that needs to support a normal retiree for the rest of his life—which will cover an unknown period of time--the three-legged stool for an early retiree need only support the early retiree for a known number of years to cover the gap between early retirement and normal retirement. For example, if the early retiree retires at 55, the three-legged income stool for early retirement need only last for 10 years. In many ways, this makes planning for early retirement more predictable than planning for traditional retirement (though it can still be more challenging!).

In building a three-legged income stool for early retirement, a potential early retiree should keep several goals in mind. First, the income stool will need to generate enough income to support the early retiree’s desired standard of living. Thus, a person contemplating retiring early needs to think about his desired lifestyle during early retirement, and how much income will be needed to support that lifestyle. Second, the income generated by the income stool should be expected to rise over time to offset the insidious impact of inflation. Luckily, since the time period for early retirement will typically be less than that for normal retirement, the total amount of inflation during early retirement will be less than during normal retirement. Third, the income stool should not be susceptible to undue market risk, such as a severe downtown in the stock market. One way to manage the market risk is to determine the level of income needed to pay the early retiree’s fixed costs, and use a conservative asset allocation sufficient to pay for those costs. Additional assets can then be invested more aggressively. Fourth, along with building the three-legged income stool for early retirement, the potential early retiree must still plan for his normal retirement years. For example, the potential early retiree will want to make sure that he will be able to rely on his normal three-legged retirement stool after he reaches his normal retirement age. One of the big challenges of early retirement is that it can make it more difficult to build this normal stool since early retirement can itself shorten the length of some of its legs, such as by causing reductions in future Social Security and pension payments due to leaving the workforce earlier and at a lower salary.

With these goals in mind, here are examples of the legs that the potential early retiree can choose from when building his retirement stool. While this article refers repeatedly to building an early-retirement income stool with three legs, there is no reason why a potential early retiree cannot include four or five or even more legs. In fact, increasing the number of legs will tend to improve the stability of that stool by increasing its diversification. By having at least three legs, the stool should remain fairly steady.

Potential Legs for a Three-Legged Income Stool for Early Retirement

1. Immediate Annuities. With an immediate annuity, an annuitant pays a fixed amount of money to an insurance company and then receives income immediately or soon after the purchase. For example, a 54-year old potential early retiree could pay $100,000 to an insurance company in exchange for an immediate annuity that will pay him $450 per month for life once he turns age 55. However, this would be a very conservative way to generate early retirement income as much of the premium would be used to buy the payments after his normal retirement age of 65. To substantially increase the payments during his 10 years of early retirement (age 55 to 65), he could instead buy an immediate annuity for a fixed term of 10 years, which would generate about $900 per month for 10 years once he turns age 55. Thus, by concentrating on building early-retirement income, his annuity payments would be about twice as large! An excellent site for pricing immediate annuities and trying different scenarios is the Income Solutions ® annuity purchase program operated by Hueler Investment Services, Inc. This website also provides quotes for inflation-adjusted immediate annuities, or immediate annuities which will increase by a fixed percentage each year, though these features will decrease the monthly payments.

2. Income Replacement Funds. With an income replacement fund, an investor purchases a special mutual fund which is designed to pay you back all of your savings and investment returns over a set time period. These payments typically include a combination of dividends, capital gains, and return of principle. For example, a 55-year old potential early retiree could invest $100,000 in an income replacement fund with a time frame of 10 years. He would then receive current-year monthly payments of $875 per month. Since the income replacement fund invests in a variety of stocks and bonds, this monthly payment is designed (but not guaranteed) to rise over time in order to provide inflation protection. Note that the monthly payments for this investment are much higher on a percentage basis than the investor could expect to receive from most other investments. This higher payment is possible because the fund is designed to make all of its payouts over its set time period, after which the balance of the account will be exhausted. An excellent provider of income replacement funds is Fidelity Investments, which offers income replacement funds designed to generate replacement income over differing set time periods.

3. Deferred Compensation. Some employees have the advantage of being able to join a deferred compensation plan during their working years. For example, a company executive may be able to invest his annual bonuses in his company’s deferred compensation plan, and then receive annual payments from this plan over a set number of years once he leaves the company. By selecting this payment period to match his early retirement period, the employee can set up a solid leg for his early-retirement income stool. For example, a 54-year old executive who receives a $50,000 bonus payable into his deferred compensation plan may be able to choose to receive deferred annual payments over a 10-year period after he leaves the company. He will then receive annual payments of $5,000 (plus investment returns) during early retirement between ages 55 and 60. Of course, this leg of the early-retirement income stool will only be available for employees who are lucky enough to have a deferred compensation plan.

4. Dividend and Interest Income. Potential early retirees can invest their personal savings in investments that will generate interest and dividend income during their early-retirement years. For example, an investor can purchase interest-producing assets such as Certificates of Deposit or U.S. Savings Bonds, or dividend-producing assets such as stocks. A good income-producing asset which generates inflation-adjusted interest income is I-Bonds, which can be purchased directly from the Treasury at TreasuryDirect.com. Good dividend-producing assets include dividend-focused exchange traded funds such as iShares’ Dow Jones Select ETF (ticker symbol DVY). Many website are available with information about these traditional investment vehicles.

5. Part-Time Work. Many early retirees supplement their income through part-time work. Early retirees are younger than traditional retirees, and are typically in better physical and mental condition, and so are in a good situation to hold part-time jobs. The key for early retirement is to find a part-time job you truly enjoy. For example, many early retirees take jobs such as golf-course starters, tutors, hobbyists who sell their crafts at weekend craft shows, novelists, fishing guides, party planners, or any other part-time job they find interesting. The financial reward from even a part-time job can be enormous. For example, if an early retiree works 15 hours per week at $10 per hour, he would earn an extra $600+ per month. It would take an investment of over $480,000 in 5-year CDs earning 1.5% to generate the same amount of income! Again, the key is for an early retiree to find a part-time job that matches his or her interests and passions.