How to avoid outliving your retirement savings

Secrets of a dream retirement
Secrets of a dream retirement

I'm trying to figure out how much I can withdraw from savings each year so I won't outlive my nest egg. I've often heard that 4% is the right amount. Is that correct? --Kevin W., Texas

The 4% figure you mention comes from studies done in the 1990s to identify safe withdrawal rates that resulted in what's known today as the 4% rule.

Here's how it works. Let's say you have a nest egg of $1 million and inflation is running at 2% a year. Basically, the rule says if you withdraw 4% of your nest egg's value, or $40,000 the first year of retirement, increase that withdrawal by 2% to $40,800 the next year, boost it again by 2% to $41,600 the third year and continue along that path, you have roughly a 70% to 80% chance that your savings will last at least 30 years.

But many retirement experts have raised doubts about this strategy in recent years. For example, research by The American College's Wade Pfau, Texas Tech's Michael Finke and Morningstar's David Blanchett suggests that, given today's low projected investment returns, you may need to limit yourself to an initial withdrawal of 3%, if not less, to avoid outliving your savings. And a recent PricewaterhouseCoopers report notes that the underlying premise of the 4% rule -- i.e., that your retirement spending will rise consistently with inflation -- doesn't always jibe with how people live in retirement. Many retirees spend more freely early in retirement, then cut back only to spend more again as they incur higher medical expenses late in life.

So where does this leave you for figuring out how much to pull from savings so you don't run out of money before you run out of time?

Unfortunately, the answer is not a simple matter of just picking a withdrawal rate that's low enough to insure a high probability of not running out of dough. For one thing, given the size of most people's nest eggs, a withdrawal rate of 3% or less just won't provide enough income for most retirees. And even if you could scrape by, starting with a very low withdrawal rate would leave you vulnerable to another risk. If your retirement portfolio generates solid gains despite current projections for subpar returns, pulling out very little each year could leave you sitting on a big pile of savings late in retirement. That may not seem like a problem. But it could mean that you lived more frugally than you had to early in retirement when you were young and healthy and might have enjoyed indulging yourself more.

Your aim, therefore, is to withdraw enough money to give you a decent shot at an acceptable retirement lifestyle while minimizing the risk of running out of dough early on or ending up with too big a stash late in life. To achieve that goal, I suggest you start with a reasonable withdrawal rate and then stand ready to make frequent adjustments from there.

What's reasonable? People argue about that question, but I'd say that an initial withdrawal of roughly 3% to 4% is a decent starting point. If you're really worried about running out of money, go with a lower rate, assuming you can get by on less income. If you're not as concerned -- perhaps you can tap your home equity or have other resources to fall back on -- you can go with a higher initial withdrawal. Just be aware that your chances of running through your money increase rapidly once you get above 4%.

You can then plug that withdrawal rate, along with such info as your age, your retirement account balances, how they're invested and how long you expect to live in retirement into a retirement income calculator that uses Monte Carlo simulations to make its projections. The calculator will estimate the probability that withdrawals from your nest egg, plus payments from Social Security and any pensions, will be able to generate the income you'll need throughout retirement. Generally, I'd say you should shoot for a probability of 80% or higher. Slip much below 80%, and you could find yourself having to scrimp late in retirement.

Most important, though, is that you're ready and willing to adjust spending as your needs and market conditions change. If your nest egg's value drops sharply, say, due to a market downturn or higher-than-expected withdrawals to cover unanticipated expenses, you may need to trim your scheduled withdrawal to avoid running through your savings prematurely.

If, on the other hand, outsized investment returns boost the value of your retirement accounts, you may be able to spend more liberally. By revisiting a retirement income calculator every year and updating your information, you can see whether the chances of your savings running out are rising, falling or staying the same, and then decide whether you need to change your scheduled withdrawal for the year.

There are other steps that may be able to reduce the chances of depleting your nest egg too soon. For example, devoting a portion of savings to an immediate annuity can provide another layer of assured lifetime income in addition to Social Security. And you may also be able to boost the size of the payments you get from Social Security by delaying when you claim benefits or, if you're married, better coordinating when you and your spouse file for them.

But ultimately, the best way to assure that you don't outlive your savings is to start with a reasonable withdrawal rate, re-assess it annually and make gradual adjustments to your spending as needed throughout retirement.

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