Market Overview

Living On the Interest from One Million Dollars

I made my first retirement plan after my freshman year at college.  Back at home, with one year of college under my belt, my good friend John and I were discussing our plans for the future.  I don’t recall the entire conversation, but I do remember saying “my goal is to accumulate a million dollars, and then cash out and live off the interest.”  I further explained that this plan would generate $50,000 a year since 5% interest seemed reasonable.

The year was 1974.  I came from a blue-collar neighborhood where typical incomes were in the $10,000 to $15,000 range.  Anyone making $20,000 was well above-average.  I believed my plan would overcome inflation, and it was based on an extremely conservative income assumption – living off the interest while never touching the principal.

It was a simple plan, but at least I had a plan.  Many people never stop and think about their retirement income until much later in life.  My plan has evolved over the years:  I am no longer content with a $50,000 retirement income, and I am not relying on interest.

Unfortunately for millions of Americans, their plan is similar to my first one:  accumulate a large amount of money and live off the interest.  They worked hard all their life, perhaps paid off their mortgage, grew a sizable nest egg, and are now counting on it to generate income.  Again, this sounds like a reasonable plan, but let’s look at how it is doing.

The two largest retail money market mutual funds are Fidelity Cash Reserves (FDRXX) with assets of $127 billion and Vanguard Prime (VMMXX) with more than $109 billion.  Funds like these are what thousands of investors and savers count on to generate “risk-free” income.

Just three years ago, in 2007, the plan seemed to be working.  These two funds were yielding 5% and kicking out $50,000 a year for every $1,000,000 (one million dollars) invested.  Today the story is different.  According to iMoneyNet, the current yield (as of 3/2/10) on FDRXX is 0.02% and for VMMXX it’s just 0.01%.  Instead of $50,000 in annual income, these two funds are only providing an average of $150 per year.  That is not a typo, and there are no zeroes missing.

What seems at first like a risk-free plan has at least two enormous risks.  The first is interest-rate risk.  The plan assumed 5% and didn’t take into account that interest rates could drop to nearly zero.  A 99.7% decline in interest income is not only possible, it has happened.

The second unmanaged risk is inflation.  If you think it’s hard to live on $150 a year today, just think what it will be like when oil gets back above $100 and health care costs climb even higher than today.  Lower prices for housing, education, and consumer goods are of limited value to retirees, whose expense patterns do not necessarily match the official inflation rates.

The fact is that money market funds are enormously risky if you count on them for income over long periods of time.  Stocks and bonds are risky, too, but in different ways.  That’s why investment management is a key ingredient for long-term success.

You can’t put all your eggs in one basket and then ignore them, even if that basket is cash,   If your plan is still based on living off the interest, or if it has been a while since you last updated your plan, perhaps now is a good time to review the assumptions and see if they are still reasonable.

Disclosure covering writer, editor, and publisher: FDRXX is used by our affiliate, Capital Cities Asset Management, as the cash-sweep fund for many non-taxable accounts.  No positions in any of the companies or ETF sponsors mentioned.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

 

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