Comparison Of Different Ways To Generate Income In Early Retirement

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As outlined in this previous post about One Way To Track Your Progress Towards Financial Independence, you can say you’ve reached financial independence when your “passive” investment income equals your monthly expenses (“crossover point”):

The above chart was taken from the Your Money or Your Life, which also says the best way to generate income is by purchasing 30-year Treasury Bonds. But there are a variety of other ways that retirees generate income for retirement. Each one has their own pros and cons.

High-Grade Bonds or Certificates
U.S. Treasury bonds are a very safe and reliable way to generate regular income, as it is guaranteed by the U.S. government and they are very liquid. A similar situation results you invest in bank CDs or other investment-grade corporate or municipal bonds. The primary drawbacks are lower returns, especially relative to inflation. The 30-year bond is currently yielding somewhere around 4.5%. The current real (above inflation) yield for a 20-year TIPS (inflation-indexed bond) is only about 2.20%.

This means that if you want both the highest safety and you wish to only live off the interest of your money without ever touching the principal, you can only withdraw about 2.2% each year. That’s only $183 per month for each $100,000.

60/40 Asset Allocation with 4% Safe Withdrawal Rate
Although there is still much ongoing debate, the “4% rule” is based on on research by William Bergen:

William Bengen, a U.S. researcher, has back-tested a 4% withdrawal rate with a balanced portfolio of U.S. stocks and government bonds earning overall market returns and found that you would have been able to safely withdraw 4% of your portfolio over any 30-year period since 1926. [source]

The general idea is that if you have a portfolio with an asset allocation of 60% stocks/40% bonds, you can withdraw 4% of the portfolio each year with only a small chance of running out of money somewhere down the line. A 4% withdrawal rate would be $333/month for each $100,000. However, your portfolio will experience wilder swings, and this rigid method is very sensitive to the returns in the first years of retirement. If you have a bad decade upfront, your chance of going broke rises quickly.

Income-Focused Mutual Funds
These are mutual funds who primary objective is not growth, but to create a stable income stream from a combination of stock dividends and bond interest. The secondary objective is some capital appreciation, which ideally will help the income stream to keep up with inflation.

A passive index fund example is the Vanguard Target Retirement Income Fund (VTINX), which is currently yielding 4.05%. A popular actively-managed example is the Vanguard Wellesley Income Fund (VWINX), which is currently yielding 4.71%. Both of these funds hold roughly 35% in stocks/65% in bonds. Wellesley has been around since 1929, and many retirees swear by the reliable income it produces.

Managed Payout Mutual Funds
A new breed of mutual funds actually adjusts to help you spend your money as fast as you like. You choose how fast you wish to withdraw your money (3%? 5%? 7%?), and the fund does it’s best to accommodate that without going broke. Vanguard has their Managed Payout Funds, and Fidelity has their Income Replacement Funds.

These funds help you create regular monthly payments like an annuity, but still include risk from the stock market. They are also very new and could be seen as unproven.

Individual Dividend Stocks
I know of several retirees who manage their own portfolios of individual stocks. These people accumulate shares in companies with a history of reliable stock dividends, like General Electric and Coca-Cola, and live off the dividends. An ETF of top dividend producers, DVY, currently yields 5.14%.

I would be wary though that the share value of these stocks can vary widely without the cushion of bonds. DVY has dropped by over 20% so far this year, which is indicative of many similar dividend stocks.

Income Annuity
With a simple version of an immediate annuity, you hand over a lump-sum upfront in return for fixed income payments for life. Of course, if you die early then you don’t get your lump sum back. However, you could live until 110. It’s almost like life insurance in reverse. A special risk here is that your insurance company must stay solvent the entire time, so you must check credit ratings.

I went to and looked into a Joint Annuity, where the income payments keep coming as long as one of us are alive. A rough quote for a 40-year old says that each $100,000 paid will get me about $450 a month. That is the same as saying I can earn 5.4% interest forever, but remember that I lose the principal. Of course, this value goes up with age. For a 60-year old couple, you can get 6.4% forever. At age 70, you can get 7.5% forever.

How much income will a million bucks get you?
Based on these numbers, with $1,000,000 one could get anywhere from $1,830 a month (very little risk, no principal loss) to $5,833 per month (fixed annuity at age 65, all principal is given up). I’d probably end up going with something in between, but it is food for thought.

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  1. Interesting article. A sidenote on the graph from “Your Money Life” — while it is probably just meant as a simplified approximation, it would be wise to factor in a long-term increase in monthly / annual expenses. Even though there may be short-term decreases, like if one stops going out to pizza every Friday, nobody would argue that it costs significantly more in dollars today than it did 50 years ago due to the inflation of the dollar.

    It is really depressing to realize that every $100,000 earns only $183 after inflation at today’s rates.

  2. "Mo" Money says

    These are the issues and decissions that everyone will face sooner or later. good article!

  3. An interesting article Jonathan. I believe you’ve covered well most souces of income for retirement. I think that buying a diversified portfolio of stocks that grow their dividends over time is a good starting point. The average yield on the S&P dividend aristocrats is above 3%.. Couple that with a 5-10 year CD rates above 5% and you have achieved a 4% income from your portfolio for a while ( assuming a 50/50 stock bond allocation).
    One thing that you could add is getting involved in real estate either through the purchase of a rental property or by purchasing shares in a real estate investment trust, which has above average yields.

    I am looking forward to reading more posts from you about investment income generation.

    Good luck in your investment endeavours!

    Dividend Growth Investor

  4. Great article, it’s never too early to start thinking about retirement.

    I don’t like the idea that every 100,000 of hard saved money only nets me $183 a month. For that reason alone I wouldn’t even think about using bonds and certificates alone. I like the idea of income focused mutual funds and managed payout mutual funds as these funds have a shot to keep up with inflation. Diversifying with income annuities seems like a good way to go.

    At this point though I’m mostly hoping for some good luck early on in my retirement years. I think it is important to pay attention to the market and adjust living expenses in early retirement years as they are crucial for determining how long your nest egg will last. Although, retiring doesn’t have to mean you stop working. Generating a little side income through a hobby like photography or blogging are great ways to supplement your nest egg.

  5. There are also fixed indexed and variable annuities that guarantee a 5% (or more depending on age) withdraw rate for life, no matter what happens to your principle, with out turning all the principle over to the company up front (like with a SPIA).

    I think that the best way to take income is to use a mix of these ideas, and always make sure you have plenty of cash for emergencies.

  6. Udo Licht says

    Unfortunately, taxes also have to be factored in. At that point, the 2.2% real rate of return on the TIPS might be more like 1%-maybe less. To live very modestly, on $20,000/year, you would need at least $2 million in the bank. You’re basically forced into a choice of taking risk or depleting your capital (or hoping that Social Security will stick around).

  7. I actually hate the idea of annuities. A family member of mine put all of their money into an annuity and proceeded to die 8 months later of a heart attack – leaving their children and grandchildren (who were not well off at all) with no inheritance.

  8. This is a highly conservative plan which most people would not need to follow. While the ‘crossover point’ does allow complete financial freedom, if everybody tried to reach it they would stay in the workforce far longer than they need. All of the Monte Carlo simulations for retirement figure in some removal of your principal, and rightly so!
    If you want to retire at 40, then sure, you’d probably better be at your crossover point in order to retire. If you’re retiring at 70, and all of your parents and grandparents died before they were eighty, it would be a waste to keep working until 72 or 73 so that you can reach your crossover point.

  9. Beware the DVY ETF. Several good companies, and several in which I wouldn’t want my investment dollars. The most worrisome aspect is the large percentage of your money that would be tied up in a single sector: financials. This would add signifigant volatility to your holdings, exactly what you are trying to avoid in retirement.

  10. great article, I really like the chart!

    I had the data in a spreadsheet format, with percentage till break-even calculated… But honestly, I like the chart approach better… very very nice.

    I think the expense line along with investment income line will increase over time too, but hopefully at a much slower rate, perhaps by 3% a year (inflation…)

    Thanks for the great information about the alternatives, I’ve never hear of “Managed Payout Mutual Funds”. My fav is the 60/40 approach. I believe with the 60/40 approach, it could still generates a return close to all stocks (maybe around .5 to 1% of a point less), without as much volatility.

  11. Jesse: Perhaps your family member did not want to leave an inheritance, there are several annuity options that allow payments to continue for several years after someone dies, sounds like a case of “Buyer Beware”.

    Either way, you should never put all of your money in one investment vehicle.

  12. Kiplinger’s had an article about this with some ‘interesting’ options.

    Some of the investment vehicles from that article:

    REITs, Energy Trusts, Closed-end floating rate bank-loan funds, foreign income funds.

  13. These are really complicated decisions. I’m thinking about your post now about living on social security alone, and how feasible this can be. Only because, if you could work it out to have your home paid for, a separate account that can accrue yearly what you need for taxes and utilities, and healthcare supplement insurance (hopefully the bulk still being picked up by the government), plus leftover for food, all taken from your social security, then the decisions are much easier.

    Annuities sound terrible when the person dies young, but when they don’t, they allow you to experience the highest quality of life (financially anyway) and minimize the risk of running out of money. But if you have the money to buy the annuity, you can probably structure the money out yourself, to pay yourself like an annuity would while living off of social security (mostly). Then you can take this fake annuity payment and put most of it back into savings, stretching the length out yourself.

  14. youngsterz says

    You should really consider some income generating real estate based options in any long term, diversified, retirement income scenario. You can get into some pretty secure investments generating 7-8% cash-on-cash returns and overall returns of 15-20%, with tax advantages, and with professionally managed master leases in place. (Tenant in Common (TIC)ownerships, for example).

    I acknowledge that many are opposed to the potential risk of real estate. I say that there are just as many risks with any securities backed investments. Like the risk that your after tax return will really be . . zero. Lower risk on T-bonds or other more secure options will definitely limit your return, and taxes are likely to just keep going up.

    I’m just saying that you should consider mixing it up a bit, and consider something outside of the usual stocks & bonds arena, ESPECIALLY if you are 10 or 20 years from retirement. I’m also saying that you MUST have a good tax strategy to get ahead, otherwise the blessed gov’t will bleed you dry.

    I don’t want to just survive on my retirement income. I intend to be quite comfortable, and well before the usual retirement age. Not filthy rich, just very comfortable. That is very difficult to do on a straight diet of stocks, bonds, mutuals, indexes and annuities. I’m looking to be at the “crossover point” well before 45. Wouldn’t be possible without a smart real estate portfolio.

  15. i completely agree with youngsterz…

    income producing real estate can yield high returns rather consistently. while not for everyone, i own a property that annually gives off 125% of my original down payment.

    there are places where you can invest $50-100k as down payment on a portfolio of rental properties in lower income areas and see $40-120k a year in cash flow.

    you can also invest in “passive” businesses such as laundromats, car washes, online businesses, etc.

    you can be a hard money lender.

    you can invest in high yielding dividend funds that throw off 15%+ annually, etc.

    i would certainly hope that with a million dollars in investment funds, you will at a very minimum be earning $100,000 a year in income.

    if this is not the case, you should consider reallocating some capital or taking a bit more risk…

    (I say this as I am decades away from being traditional retirement age so I am more accepting of risk.. those in their 60s+ may choose to invest in fixed income alternatives at lower yields.

  16. The value of any of these strategies will depend in large part on whether the retiree intends to leave substantial assets in his/her estate to pass on to heirs. If not, there is no need to rely strictly on passive income. Indeed, from a consumption smoothing point of view, this can lead to oversaving and therefore poor investment decisions.

  17. this is why people end up owning small to medium businesses or things like rental properties. obviously there is a wide range of involvment required, but that all depends on how you manage it. several older family friends of mine passively own business or office/retail space that is managed by another party (silent owner).

    in my opinion this really helps make up the gap on some of the more standard investment routes you outlined (a setup somewhere on that spectrum you gave should be a given for readers of this blog).

    edit: looks like bryan beat me to the punch on this one.

  18. Ditto the comment on DVY. It is almost like a financial sector ETF, and we all know how financials have done lately. That said, the nice thing about a consistent dividend paying stock going down is the dividend yield essentially becomes higher. At this point though, DVY has a much riskier profile than you would historically associate with this type of fund.

  19. I hope to retire in the next 10 years and one of my goals will be to protect what I have while generating a decent rate of return. My plan right now is to put the money I want to protect in quality dividend paying companies whose share prices are on sale so that I have the opportunity for capital appreciation as well as increasing dividend yield on my original investment.

  20. Doubleclick says

    Just a thought… someone who considers themself savvy enough to monitor a portfolio of dividend stocks might consider using covered call options to smooth out volatility, and use puts and calls to enter and exit stocks.

    Hey, wow, this is a slick commenting system you have! I like the 5 minute edit ability.

  21. What is your take on Fixed Income ETFs (such as advertised on the back page of today’s WSJ Section A)? Basically bond funds without having to buy the bonds. HYG or AGG, for example.

  22. I’m currently using Vanguard Short-Term Investment Grade bond fund (VFSTX) current yield about 4.50%. Check writing for 250 or more.

  23. To my knowledge, a few best of the highest-grade corporate bonds such as GE’s have higher yield (6% — 8%) than Treasury’s and could be considered a fraction of the portfolio. Any comments or historical results?

  24. Johnathon,

    I would have mentioned reverse mortgages for people who have their houses payed off. That equity isn’t going to do you any good sitting in your house if you don’t have other means of income, and you still get to live in your house.

  25. My understanding of the 4% rule is that you take out 4% of the your portfolio in the first year of retirement and then each subsequent year you take out the dollar amount from the previous year plus inflation. It’s not just 4% of that year’s portfolio.


  26. You might want to consider Vanguard’s Wellington fund (VWELX), it yields around 3.5%, little less than Wellesley fund, over long periods of time it performs better than Wellesley by several percentage points.
    I am surprised that no one (especially mutual fund companies) has figured out a way to get around 5% yield with at least 8% total return over long periods of time with little deviation.

  27. Here is how I read this. I have read these sections of the book ” Your Money or your life”. I am not sure why the author recommends taking long term interest like treasuries and then multiply with how much you save every month. That might not work well for all. A beginner should start with what he makes from this passive investing. This graph will be a spike for both the monthly expenditures and monthly passive income. A second graph which averages out the whole might make a lot of sense.

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