Retirement: The 4 percent solution

NEW YORK (Money) -- Question: I've read that if I withdraw roughly 4 percent of my retirement savings each year to live on, my money will last virtually forever. But does this 4 percent include the money my portfolio already kicks off in dividends and interest? Or is the 4 percent withdrawal on top of that? - Doug Martin, Syracuse, New York

Answer: First, let me say you're not the only person mystified by the workings of the 4 percent withdrawal rule. I get questions about it all the time, so I'm happy to clear up the confusion.

And while I'm doing that, I'd also like to point out that, like any rule of thumb, this one is really only a general guideline. It's not as if the Retirement Gods have decreed that everyone must use a 4 percent initial withdrawal rate, or that doing so guarantees the best retirement.

But before I get into some of the subtleties about this oft-quoted rule, let me explain how it works. Many people think that the 4 percent rule means that you simply withdraw 4 percent of retirement savings each year. But that's not right. In fact, the 4 percent figure applies only to the percentage of your savings that you withdraw the first year of retirement.

You then increase the dollar amount of that initial withdrawal for inflation each year.

So, for example, if you have $1 million in your 401(k), you would pull out $40,000 the first year. If inflation were running at, say, 3 percent a year, you would increase that amount to $41,200 the second year, roughly $42,400 the third year and so on.

The idea is that by boosting your withdrawal by the inflation rate each year, you maintain your purchasing power throughout retirement. And it can also make budgeting a little easier since you know how much money will be coming in each year.

As to your question of whether that 4 percent plus subsequent increases for inflation should include dividends and interest, the answer is yes. The idea is to draw a given amount of money from your portfolio, regardless of whether you get that amount from interest, dividends or sales of investments.

So, let's say that $1 million 401(k) I mentioned earlier was invested 50 percent in stocks and 50 percent in bonds. And let's assume that the bond portion yields 5 percent, and thus throws off $25,000 a year and that your stock holdings yield 2 percent (roughly the same as the Standard & Poor's 500), generating $10,000 in dividends. That would give you $35,000 of cash, which means you would have to sell some holdings to generate the other $5,000 you need to get to $40,000.

Remember, though, that in subsequent years, you'll have to raise more than $40,000. After 15 years of 3 percent annual inflation, for example, you would have to withdraw more than $62,000 to have the same purchasing power as $40,000 today. Which is why it's important to have a portion of your portfolio invested in stocks for growth.

I've used a 50-50 stocks-bonds mix as an example here, but in fact the amount you have in stocks will depend on your age, tolerance for risk and how sure you want to be about not running out of money.

Generally, though, someone 65-years-old would probably want to have roughly 50 percent to 55 percent of his or her money in a diversified portfolio of stocks and the rest in bonds. As you age, you would gradually shift more of your portfolio into bonds.

But even by your mid-80s, you probably want 20 percent to 30 percent of your holdings in stocks. After all, with life spans being what they are these days, you should probably plan as if you'll live at least into your early to mid-90s. The last thing you want is to arrange things so your money lasts only into your 80s and then find yourself a nonagenarian forced to scrape by on a subsistence level income.

As I mentioned earlier, however, it's not as if a 4 percent initial withdrawal is engraved in stone. The reason many pros recommend this rate is because studies show that it provides a high (but not absolute) level of assurance that your savings will last 30 years or more.

Starting at a low rate also makes it less likely that the combination of withdrawals and a big market downturn early in retirement will put so large a dent in your portfolio that it can't recover, forcing you to dramatically scale back your draws later in retirement.

On the other hand, if you get through the first five to 10 years of retirement without running into a stretch of lousy returns, sticking to the 4 percent rule could not only prevent you from running out of money; it could also result in you having a huge portfolio late in retirement, despite your withdrawals. That might not be such a bad thing if you're able to live the life you want on a 4 percent initial withdrawal rate.

After all, having a cushion of assets could come in handy in the event you need some extra dough to handle health-care costs in your later years. Or you may just want to leave some money to heirs. But retiring on the 4 percent plan and ending up with a big fat portfolio balance late in life wouldn't be such a wonderful thing if it meant you had to live like a pauper during most of your retirement. What would be the fun in that? Of course, you can avoid that possibility by starting out with a higher withdrawal rate, say, 5 percent or 6 percent, which will give you more spending cash.

And if the markets are kind, your savings may still support you for 30 years. But if you earn subpar returns - particularly early in retirement - you could end up going through much of your savings while you've still got a lot of living to do. So what's the answer? Well, it comes down to how long you think you'll need your money and how much assurance you want that it won't run out.

If you think you'll be relying on your savings for 30 or more years and the idea of running low on dough late in retirement really makes you anxious, then you'll probably want to go with a 4 percent initial withdrawal rate - or at least not go very much above it.

But if you feel you won't need income for that long - either because you're retiring late or because your health is such that you think you'll end up on the wrong side of the longevity curve - then you might want to consider a withdrawal of 5 percent or more.

Ditto if you're just not that worried about running low late in retirement, perhaps because you've got other resources to fall back on (home equity, cash value in a life insurance policy, rich relatives).

Keep in mind too, that there's no law that says you've got to stick to a withdrawal rate for life. You could always start out with 4 percent and increase it if you feel you need more income to get by. Or, for that matter, you could start out with a higher rate so you have more money early in retirement when you're more likely to want to travel and engage in active pursuits, and then cut back a bit as you become less active later on.

However you decide to go, it's a good idea to check in once a year or so just to make sure you're not going through your savings too quickly - or that you're not unnecessarily stinting while your portfolio's value balloons.

You can do that by going to T. Rowe Price's Retirement Income Calculator, which shows you the odds of savings being able to sustain different levels of withdrawals over varying lengths of time. You can also see how different mixes of stocks, bonds and cash affect the odds.

You can do much the same analysis with even more detail, such as factoring in your specific retirement expenses and even different rates of inflation for different expenses, by going to Fidelity's Retirement Income Planner tool. (You don't have to be a Fido customer to use the tool, but you do have to register at the site.) Fido's Retirement Income Planner tool also allows you to factor an immediate annuity into your strategy.

Although I'm not a big fan of most annuities for retirement planning, I think immediate annuities can sometimes play a valuable role for creating assured income in retirement and extending the longevity of the rest of your savings. For more on this, I suggest you check out a story I wrote last year for Money Magazine titled "An Income Plan That's Built To Last."

Whatever withdrawl rate you choose, as a practical matter I think it makes sense to keep, say, 18 months or so worth of spending cash in a money-market fund or other secure account. This way you can easily transfer whatever you need for living expenses and the like into your checking account. (Or, for that matter, you could just write checks on the money-market fund account.)

You can funnel dividends and interest from your portfolio into this account. And you can also replenish this account with however much more cash you'll need for the next year and a half or so by selling shares of investments in your portfolio.

Ideally, you should try to do most of this selling at the same time you rebalance your portfolio every year. So, for example, if large-company stocks have become too large a percentage of your portfolio because they've outperformed other investments you own by a wide margin, you can sell enough shares to bring your large-cap stock holdings back in line and use some or all of the sale proceeds to top off your spending-cash reserve.

By doing this, you get the income you need from your savings and keep your portfolio in shape at the same time. Bottom line: I recommend that you think about the 4 percent withdrawal rule not as a commandment, but a starting point for creating a withdrawal strategy that works best for you.