Living off the interest? Good luck
Few people will amass a big enough nest egg to live without touching principal. Here's a spend-down strategy for everyone.
By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- When it comes to withdrawing money from savings for retirement, why don't more advisors encourage people to just live off interest and dividends and leave the principal alone?

This approach would alleviate the worry of not having enough to live on late in retirement and would also assure you could leave an estate for heirs. That's my plan anyway, and that's what my father did as well. Why don't more advisors recommend this strategy? - Kip M., Boise, Idaho

ANSWER: The main reason advisers rarely recommend that people live off interest and dividends and leave the principal alone is that few retirees have a large enough nest egg to pull off such a strategy.

Let's assume, for example, that someone is retiring with $500,000 in retirement savings. That's already a generous assumption since it's a lot more than most retirees have, but let's go with it.

And let's further assume that our fictional retiree's half a million bucks are divided 50-50 between a diversified portfolio of stocks and a diversified group of bonds. The Standard & Poor's 500 index currently yields less than 2 percent a year, but again we'll be big-hearted and assume a 2 percent yield. That means the stock portion of the portfolio will throw off about $5,000 in income the first year of retirement.

As for the bond portion, let's figure the bond portfolio yields 5 percent a year, a reasonable estimate for today's market. So the bonds are throwing off $12,500 a year. Add that to the dividend income and our retiree has a grand total of $17,500 in income.

Now, even if someone can get by on that amount, there's another issue: you've got to factor in inflation. Your income would have to rise for your spending power to stay even with rising prices. If prices rise at, say, 2.5 percent a year (which is less than the average inflation rate over the past 80 years or so), you would need just over $22,000 of income to maintain your purchasing power in 10 years and almost $29,000 to keep your spending constant at 20 years.

Granted, I'd expect the dividend portion of the portfolio to keep pace with inflation. But bond interest payments are fixed. So gradually you would fall behind inflation. So in order to maintain your purchasing power, you would have to dip into your principal.

Sure, there may be some adjustments you could make, like buying stocks that pay higher dividends or bonds that make higher interest payments. But those sorts of move always involve taking more risk, whether concentrating your portfolio in industries with higher dividend payouts or buying lower-quality stocks that are forced to pay more dividends or moving to high-yield (i.e. junk) bonds for their fatter yields.

These moves may get you the extra income you need without any problems. Or you could end up with stocks that crash and bonds that default.

Plan B

So what's the alternative?

Well, the first thing to do is to invest whatever size nest egg you've managed to accumulate in a diversified portfolio of stocks and bonds (or, more likely for most people, stock funds and bond funds). That portfolio can certainly contain dividend-paying stocks and even some high-yield bonds. But it should be broadly diversified so that you've got large and small stocks and growth and value shares.

For the bond portion, you can keep things simple and stick to Treasuries, or you can also throw in some corporates or, depending on your tax bracket, munis. Either way, you want to have a range of maturities from, say, two to 10 years. (Or in the case of bond funds, you could just stick to funds with average maturities of, say, four to seven years.)

The percentage of your savings that you would devote to stocks vs. bonds depends both on your tolerance for risk and how long you would like your portfolio to last. If you're at the beginning of retirement, you should probably plan for an investing horizon of 30 or more years. To provide reliable income that can stand up to inflation, you're likely talking about a portfolio that has 50 percent or so of its assets in stocks and 50 percent in bonds. That should give you a good trade-off between growth and stability.

As you age, you'll want to gradually shift more into bonds, although even in your 80s, you still need some stock exposure, say, 20 percent to 30 percent of assets.

Once you've got a portfolio that can deliver both long-term growth and current income, you can turn to the question of how much money you can reasonably expect to withdraw each year without running too big a risk of your stash running dry.

There's no magic number, but for a reasonable likelihood that your money will last 30 or more years - which is what you should probably be planning for at age 65 - you shouldn't withdraw more than 4 percent to 5 percent of your portfolio's value the first year of retirement.

Now, a 4 percent initial withdrawal on a $500,000 portfolio amounts to $20,000. Hardly a fortune, and not much more than the amount you got just drawing dividends and interest. But there's a big difference. That 4 percent is for the first year only. You would increase the dollar amount of that initial withdrawal the next year for inflation, and then increase the second year's draw for inflation, and the third year's, the fourth year's and so on.

So if you start at $20,000 the first year, by the 10th year, you'll be pulling about $25,600 from savings, assuming a 2.5 percent inflation rate and by the 20th year you'll be drawing almost $33,000.

That inflation increase is one reason you've got to start at a relatively low withdrawal rate. The other reason is that the combination of drawing money from your portfolio and a market downturn can have a devastating effect on a portfolio's value, especially if the setback occurs early in retirement.

Of course, if you don't run into a market downturn and the market's returns are generous, there's a good chance you might not have to dip into principal. Your portfolio's value could very well grow.

But because of the uncertainty, it pays to err on the side of conservatism when it comes to spending down your savings.

If you follow this strategy of creating a diversified portfolio and starting with a low-to-moderate initial withdrawal rate, the odds are pretty high that your money will support you throughout a retirement that could last 30 or more years.

You can increase the odds in your favor even more by putting a piece of your savings into an immediate annuity (aka an income or payout annuity), an investment that pays a guaranteed lifetime income. Research shows that a portfolio of stocks and bonds combined with the steady payout of an income annuity increases the odds that a portfolio can pay a sustainable income over long periods. Read more on this annuity strategy.

Of course, you can also stick to your strategy of just living off dividends and interest without dipping into principal. But you're going to need a pretty big nest egg - or be able to get by on a pretty small income - to pull it off.

______________________________________

Ask the Expert: Dear reader, don't play George Soros What's wrong with holding cash, waiting to buy stocks at more attractive levels? Plenty.

Ask the Expert: Rollovers: 3 options rated When you switch jobs, it's the move you absolutely have to get right.

Ask Walter a question: E-mail us at asktheexpert@turner.comTop of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.