A near-retirement plan

NEW YORK (Money) -- Question: My father-in-law is 58 years old and has about $300,000 saved for retirement. He plans to retire with this amount plus whatever he can save in the next seven years. I expect he will qualify for only a little in the way of Social Security. I've read that retirees shouldn't withdraw more than 4 percent to 4.5 percent of their nest egg annually in retirement. But my father-in-law claims he can easily get a double-A or triple-A rated bond that will pay 6.5 percent to 7.5 percent, so a higher withdrawal rate should be no problem. Am I right to be concerned about his retirement security? - J. Jordan

Answer: I know this much: You're certainly justified in worrying about your father-in-law's knowledge of the bond market. The last time I checked, yields on high-quality corporate bonds ranged between 4.5 percent and 6 percent, not 6.5 percent to 7.5 percent. (To see the current range, click here.)

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You could get 7.5 percent or even more by going into the junk pile - that is, buying non-investment-grade high-yield bonds. But I don't think that's where anyone's retirement nest egg belongs, or at least not any significant part of it.

Even if your wife's dad could find high-quality corporate bonds paying 6.5 percent or more, he wouldn't want to put his three hundred grand in just one bond, or even a small handful. That would leave him vulnerable to defaults since there's no guarantee that what's rated double- or triple-A today will be at that level for 30, 20 or even 10 years.

As we've seen with the subprime mortgage-backed securities of late, downgrades happen. So to seriously consider buying individual bonds, your father-in-law would have to know how to build a portfolio of individual issues - I'd say 10 at a minimum - with varying maturities and different issuers. I'm not claiming you have to be a rocket scientist to do this. But it does require some knowledge, as well as the willingness to monitor the holdings.

And even if your father-in-law is jiggy with that, it still wouldn't make sense for him to put his entire nest egg in bonds. Why? Well, bonds are a good way to get income, but they don't offer much in the way of growth potential. Which means his income wouldn't keep up with inflation, and his purchasing power would likely decline over time.

So what should your father-in-law do to create a steady income that will support him when he eventually retires? Basically, there are three steps anyone in his position should take:

Although he's got several more years of work ahead of him, now is the time your father-in-law should try to get a good sense of how much money he'll actually need to meet his expenses once the regular paychecks stop. Otherwise, how can he really know whether he'll have enough resources to live an acceptable life style once he retires?

He can do something as simple as take a pencil and a pad of paper and jot down what he now spends in various categories (housing, transportation, food, entertainment, health care, etc.) and then estimate what those expenses might be in retirement. Or he could do an electronic version using software or an online tool.

For example, Fidelity's Retirement Income Planner has a budgeting worksheet that allows you to break down your spending into 49 different categories. This worksheet can even take into account expenses that may be scheduled to expire during retirement, such as a mortgage. (You don't have to be a Fido customer to use this free tool, but you do have to register at the site.) The advantage of going the digital route is that you can more easily update your budget as you near retirement.

Here, I'm talking about guaranteed income such as Social Security benefits and pension payments, if any. You say that you expect his Social Security payments won't amount to much. Well, there's no need to guess. You can get anything from a quick estimate to a much more accurate one by going to the benefit calculator on Social Security's web site.

The Social Security administration also mails to anyone 25 or older who has worked an annual Social Security Statement that estimates scheduled benefits. If your father-in-law doesn't have that statement handy, he can request one online, call 800-772-1213 or stop by a local Social Security office. For an example of what that statement looks like, click here.

Presumably, the income your father-in-law will receive from Social Security and pensions, if any, each year won't be enough to cover all his annual retirement expenses. So he'll have to tap his investments to cover the gap.

Remember, though, however large that gap is, it's likely to grow as prices rise in the future. So if you want to maintain your purchasing power over a long retirement, you've got to factor in inflation when figuring out how much money you must pull from your portfolio each year. (Your Social Security benefits, on the other hand, automatically rise with inflation.) This is where withdrawal rates come in.

Most advisers recommend that people start with an initial draw of 4 percent to 5 percent of your retirement portfolio and then adjust the first-year dollar amount for inflation each year.

So, for example, if someone has $600,000 (which is a reasonable estimate of what your father-in-law could have if his $300,000 grows at 8 percent and he adds $500 or so month in new savings for the next seven years), a 4 percent withdrawal would generate $24,000 in income the first year of retirement.

If inflation cruises along at 3 percent a year, that draw would grow to just over $24,700 the second, year, to nearly $25,500 the third, a bit more than $26,200 the fourth, etc.

I stress, though, that this 4 percent to 5 percent initial withdrawal isn't carved in stone. Many advisers have settled on this range because by limiting your initial draw to 4 percent to 5 percent and then adjusting for inflation, you increase the odds that your portfolio will last at least 30 years.

You could draw more, however, if you're okay with a higher chance of your savings running down sooner. And there's nothing that says that once you start out on a given withdrawal rate that you're forced to stick with it. (For more on the ins and outs of withdrawal rates, check out this column I wrote on the 4 percent rule earlier this year. To see how long your money might last at different withdrawal rates, check out T. Rowe Prices Retirement Income Calculator.

So the question is how do you get the money you need each year from your retirement portfolio? One way is to just withdraw the money from your account. But while starting with a low initial withdrawal rate considerably lowers your odds of running through your stash too soon, it's still possible.

Another way to go would be to invest your savings into a vehicle that guarantees a certain level of income, such as an annuity. There are several types of annuities that can provide income. But the one I generally prefer is an immediate annuity, which converts a lump sum into a monthly payment that can last as long as you live (or as long as you or your spouse is alive).

There is a downside, though. Once you "annuitize" your savings, you no longer have access to that money for emergencies. So it wouldn't make sense to annuitize all, or probably even most, of your savings.

A strategy I think it's worthwhile to consider is putting a portion of your money in an immediate annuity - say, enough so that the annuity payment combined with Social Security and any pension payments covers the bulk of your basic expenses - and then keep the rest in a portfolio of low-cost mutual funds. I outlined this strategy in a story in Money's November issue titled "Make Your Money Last".

Keep in mind, too, that you can take the pressure off your retirement portfolio by working a bit during retirement. Earning a few extra bucks means you won't have to draw as much from savings, and a job can also have the benefit of keeping you socially engaged.

That said, you've got to be realistic about what sorts of retirement jobs are out there and what they pay. For more about that, check out my "Working In Retirement: Five Questions", which is also in the November issue of Money.

As with creating a bond portfolio, I don't think you've got to be a financial whiz kid to create a retirement income plan on your own. But if you don't have a knack for finances or you just feel uncomfortable taking on a task like this, then it probably makes sense to talk to an adviser.

Even there you've got to be careful, though, since some "advisers" are really more interested in selling products that can generate income but also come with lofty fees. (For an example of such a product, click here. And for advice about choosing an adviser, click here.)

So as I see it, your father-in-law has two basic choices. One is to bone up on these issues in the time he has left before he retires and create a retirement income plan on his own. The other is to keep saving and socking away as much money has he can and then within a couple of years of his planned retirement sit down with an adviser to create an income plan.

But I don't think he should count on buying a bond or two and hoping they'll carry him through retirement. If he does, your father-in-law could very well end up getting a very expensive lesson about the bond market and retirement planning that he will never forget.