The ideal retirement withdrawal rate

  @Money November 2, 2012: 3:21 PM ET
NEW YORK (Money Magazine)

I hear I can take only 4% a year from my portfolio. Why can't I take more? -- Alfred Williamson, White Hall, Md.

The oft-cited rule is to start by pulling 4% from your savings and then increase the dollar amount of that draw by the inflation rate each year to keep up your purchasing power. (That annual inflation adjustment is why you can't just withdraw what your investments earn.)

Do that, and you have a good chance that your nest egg will support you for decades.

Real-world complications, though, can wreak havoc with the 4% strategy -- just ask anyone who left work on the eve of the 2000 or 2008 bear markets.

Here's the hitch: Even if you could know in advance what average return you'll earn in retirement (which, of course, you can't), you wouldn't know what your savings would earn from one year to the next.

With a mix of stocks, bonds, and cash, you'll have some years when returns are excellent, others when they're average, and some when they're downright dreadful. And when you're drawing cash from your portfolio, it's the year-to-year ups and downs that help determine how long your savings will last.

Related: Tame the threat of inflation in retirement

After decades of paying attention to long-term averages while you saved, you need to readjust your thinking.

As the table below shows, when you suffer a sizable setback or a string of lousy returns, especially early in retirement, the combination of rising withdrawal amounts and subpar performance can so seriously deplete your portfolio that your chances of running through your savings dramatically increase.

The fact is, given all the uncertainties in retirement -- how your investments will perform, what your actual expenses will be, how long you'll live -- you can't pick the ideal withdrawal rate in advance. You'll either deplete your savings too soon or leave behind money that you could have enjoyed.

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A better strategy: Start with a reasonable withdrawal rate like 4% and fine-tune as you go.

You can do that with an online tool like T. Rowe Price's Retirement Income Calculator. Plug in the value of your savings and the amount you'd like to take out each year, and you'll get an estimate of the probability you'll be able to maintain that rate of spending. With uncomfortably low chances -- say, less than 70% -- scale back.

Related: Make your retirement savings last

Repeat this every year or so. If a market downturn has depressed the value of your nest egg so much that the probability of your dough lasting has significantly declined, forgo an inflation adjustment or trim your withdrawals until the outlook improves. When the markets have done well, on the other hand, you may be able to boost your withdrawals and indulge yourself. The key is to stay flexible. To top of page

The Perils of an Early Setback
A steep market drop in early retirement can really ding you, even with a 4% withdrawal rate. You need to be willing to make adjustments to stay on track.
Chances of Portfolio Lasting 30 Years
At age 65 78%
Portfolio is down 15% three years later 59%
You trim withdrawal 10%, then resume inflation hikes 72%
Note: Assumes 50% stocks and 50% bonds, annualized 8.1% return for stocks, 3.8% for bonds, 0.5% annual expenses, 2.5% inflation. Sources: David Blanchett, Morningstar Investment Management; Money research
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