Retirement: A number you can live with

How big a nets egg do you need to retire comfortably?

At first glance the math is discouraging. Conventional financial planning research says someone retiring at 65 should withdraw no more than 4% a year of his or her original portfolio, with subsequent increases in the dollar amount to cover inflation. Based upon that assumption, you need to build a retirement nest egg that is 25 times the amount of income you require from your investments. So if you want to generate the inflation-adjusted equivalent of $20,000 a year from your portfolio, you need to put away half a million bucks.

Most people are shocked when they learn this, especially if they’ve been counting on their portfolio to produce 5% to 10% payouts in retirement. To most people, a 4% withdrawal rate seems like a piddling amount — especially when you consider that your investment returns are usually much better than 4% a year. But before you scoff, it’s important to understand what lies behind the magic number four.

It’s predicated on the notion that a stock market slump, especially early in your retirement, can devastate your retirement. Stocks have lost 45% or more of their purchasing power on four occasions since 1926 — the most recent time occurring between 2000 and 2002. If you’re unlucky enough to retire just before one of these “super” bear markets, the slump can demolish your carefully laid-out retirement plans. Even if you only get sideswiped by several years of unusually low returns early in your retirement, you can wind up with far less than you had bargained on.

That’s where the 4% withdrawal rate comes in. If history is any guide, a 4% withdrawal rate means your portfolio will be able to withstand a market meltdown of the worst magnitude we’ve experienced in the last 80 years as well as support you for an exceptionally long life. 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. (Of course you might live longer than 30 years in retirement, so there’s still a tiny chance of running out of money. Some researchers put those odds of ruin at about one in 20, which most people find tolerable.)

What happens if you withdraw just a little bit more — say 5% a year — without any other adjustments? Your risk of failure more than doubles. At 5%, researchers put the odds of you ending up penniless at about one in nine. That’s a lot dicier. So what can you safely do if a 4% withdrawal rate isn’t enough to cover your needs? Consider these three simple strategies:

Take out 5% a year, but cut back if your portfolio shrinks. Let’s say you start with half a million dollars. Under this plan, you would initially take out 5% a year, or $25,000. A year later, if inflation has been running at, say, 2%, you would bump up your annual withdrawal to compensate. So you would withdraw $25,500. (The initial dollar amount plus 2% inflation.) Each subsequent year you would proceed in the same fashion, taking out the inflation-adjusted equivalent of 5% of your original portfolio.

So what happens if your returns aren’t big enough to offset the 5% withdrawal rate? You immediately cut back to withdrawing only 4% a year.

While there are no precise estimates of the risk of running out of money under this strategy, it shouldn’t be much greater than that of a constant 4% withdrawal rate. That’s because a great part of the risk of running out of savings comes from being hit with a super bear market right after retirement starts. If such a disaster happens, you would be knocked back to the 4% rate right off the bat and this strategy would work pretty much the same as the constant 4% approach. But at least this approach gives you the benefit of increased income if your portfolio prospers.

Use life annuities. A life annuity is an arrangement in which you hand an insurance company a lump sum of money and the company guarantees to pay you a given amount for as long as you live. The most straightforward type of annuity is very much like an old-style company pension — it guarantees to pay you a “defined benefit” of so many dollars a month for the rest of your life.

A life annuity ensures that you will never run out of money, even if you live to 100 or beyond. Properly used, an annuity can allow you to increase your safe withdrawal rate by one or two percentage points a year without increasing the risk of ruin, says Moshe Milevsky, a professor at York University’s Schulich School of Business. Thus you should be able to achieve an overall safe withdrawal rate of at least 5%.

Before you buy any annuity, it’s important to do your research and compare products. Fixed payment life annuities give you a set dollar amount (generally not adjusted for inflation) for as long as you live. A more complicated arrangement is what is known as a variable annuity with guaranteed minimum withdrawal benefits for life. These products typically incorporate stock and bond investments, so you benefit, to some degree, from a rising market. But they also guarantee you a minimum withdrawal for life, so you don’t have to worry about running out of money if the market crashes.

Annuities make most sense for healthy retirees who don’t already have a defined-benefit pension plan from their employer. If you fall into that pension-deprived group, Milevsky suggests you consider gradually adding fixed and variable life annuities to your portfolio in the first few years after you turn 65 until they comprise roughly one-third of your portfolio at 75. The drawback? While life annuities are a great way to increase your safe withdrawals, they tend to do so at the cost of reducing the amount of money that you are able to leave to your heirs. These often complex products have many other pros and cons, so look closely before buying anything and if in doubt seek professional counsel from a fee-only planner or other unbiased professional.

Own your own home. If you’re tempted to withdraw more than 4% a year, you can reduce your risk of disaster by first paying off your mortgage. Owning your own home allows you to live on less than you would need if you were paying rent; in addition, you can borrow against the equity in your home if you’re hit by an emergency. If the time comes when you want to move into an assisted-living home or long-term care facility, you can sell your home to help pay the bill.

What happens if you simply can’t make ends meet on 4% of your portfolio a year, or anywhere close to it? You may have to consider reducing your income expectations or looking for other sources of income. If in doubt, talk to a financial adviser about developing a detailed plan that works for you. A good source of further information about conventional stockand- bond safe withdrawal strategies is William Bengen’s Conserving Client Portfolios During Retirement, which is available from Amazon.com.