Making your nest egg last a lifetime

(Money Magazine) -- Question: I often see articles recommending a 4% withdrawal rate to avoid running out of money in retirement. But it seems to me that if you earn a 4% return, which isn't excessive, you could withdraw 4% of your savings forever without ever touching principal, let along run through your savings. Am I missing something? -- John N., Washington, D.C.

Answer: Actually, you're missing a couple of things, although that hardly puts you in select company when it comes to the 4% withdrawal rule. It's one of the most widely misunderstood rules of thumb around, with the confusion surrounding not just the way it actually works, but the risks involved if strictly adhering to it.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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So let's clear up some of the misconceptions.

You're correct in saying that if you have, say, $1 million saved, earn a 4% return on that million bucks each year and then withdraw 4%, or $40,000, every year, you could continue doing that ad infinitum without dipping into principal. (This assumes you take your withdrawal at the end of the year. If you take it at the beginning, you'd have $960,000 left and need a 4.2% return to get you back to $1 million.)

But that's not how the rule works. The assumption behind the 4% rule is that a retiree wants to maintain purchasing power throughout retirement. In order to do that, the rule pegs the dollar amount of the initial withdrawal to the inflation rate.

So if we assume just for the purposes of this example that inflation is running 3% a year, then you would withdraw not $40,000 your second year of retirement, but $41,200 ($40,000 plus a 3% increase for inflation). In the third year, you would withdraw just under $42,400 ($41,200 plus 3%). By the 10th year you would be withdrawing roughly $52,200 and by the 20th year more than $70,000.

Which means that in order to avoid tapping principal, you would have to earn a steadily rising rate of return: 4.12% the second year of retirement, 4.24% the third and, by the 20th year, about 7%. So that 4% return you see as so attainable won't cut it if you want to maintain your purchasing power. Essentially, your return would have to increase annually by the rate of inflation to assure that you could leave principal undisturbed.

The second place people go wrong with the 4% rule is in assuming that the returns needed to fund withdrawals will come in on target year after year with clock-like precision.

But that's unrealistic. Why? Well, to have a decent shot at earning returns that are high enough to generate sufficient income initially plus keep pace with inflation, most people will have to invest in a portfolio that contains at least some stocks and bonds. And when you invest in stocks and bonds -- as opposed, say, to CDs -- you won't earn a predictable return year after year. The return will fluctuate with the financial markets.

That volatility has consequences.

One is that if you suffer a loss or a string of subpar gains, especially early in retirement, the combination of rising withdrawals and lousy returns could so deplete your portfolio's value that you might not only have to dip into principal -- you might run out of money altogether.

Granted, the odds of going through your savings following the 4% rule aren't very high -- about 15% to 25%, depending on how you divvy up your portfolio between stocks and bonds and how the financial markets perform. The chances of running dry are high enough though, that following the 4% rule is far from a slam dunk.

But there's yet another risk to the 4% rule that gets less attention -- and at first glance may not seem like a downside at all. Namely, if your portfolio performs well, your savings may not only last, but you may even have lots of money left after 30 years, possibly much more than you started with.

This may not seem like much of a drawback. And maybe it isn't if you're okay leaving all the moolah you didn't spend to your heirs. But a having a huge pile of dough late in life also means that you could have made larger withdrawals -- and perhaps enjoyed life more -- early in retirement. In other words, by restricting yourself to a 4% initial withdrawal adjusted for inflation, you may end up leading a more meager existence you actually need to.

For a more comprehensive look at the risks of the 4% rule, I suggest you check out this paper by researchers at Financial Engines. The bottom line, though, is that the 4% rule isn't some magical system guaranteed to provide the surest, safest and most efficient stream of income in retirement.

That said, until something distinctly better comes along, I think it can provide a decent framework for turning balances in 401(k)s, IRAs and other accounts into a reasonably reliable retirement paycheck -- provided you compensate for the risks.

One way to do that is to remain flexible, say, paring withdrawals or doing without an inflation adjustment if your portfolio has taken a hit and boosting draws if you've had a run of above-average returns. You can also reduce the ups and downs in the value of your savings by tilting your portfolio's allocation more toward bonds and cash (although realize that you'll also be reducing the potential for return). You might also consider devoting some assets to an immediate annuity, an investment that can provide guaranteed income and help extend the longevity of your savings.

And just to be sure you're not going through your savings too quickly -- or too slowly -- you might periodically go to T. Rowe Price's Retirement Income Calculator, which can help you gauge your portfolio's likelihood of sustaining a given level of withdrawals.

What you shouldn't do, though, is just blithely follow the 4% rule and assume that everything will work out just fine.

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