(MONEY Magazine) – It's one of the greatest lines in one of the greatest movies of all time, The Wizard of Oz. Dorothy Gale, played by Judy Garland, has just been transported, along with her little terrier, Toto, from her Kansas farm to a mysterious place called Oz. Bedazzled by the bizarre landscape, she looks around and then utters those famous words: "Toto, I have a feeling we're not in Kansas anymore." When it comes to describing the situation you face today when planning for retirement, I can hardly think of a better line: You're not in Kansas anymore. The old familiar world where you could count on government and corporate largesse for a comfortable retirement has given way to a new environment, one as alien to the world we knew before as Kansas is to Oz.

This transition certainly complicates the process of saving for retirement, but the challenges only get worse once retirement begins. At one time Social Security and traditional corporate pensions made sure income kept flowing to retirees. However, few people can count solely on either source anymore. That means the lifestyle you'll enjoy in retirement will depend largely on how deft you are at converting the assets you've accumulated in 401(k)s, IRAs and other investment accounts into a stream of income you can live off in retirement. The ultimate goal: making sure you don't run out of money before you run out of time.

Unfortunately, this is the part of retirement planning most folks think about the least—which is kind of ironic, because how well you execute the drawdown phase of your retirement plans is even more important than how you handle the accumulation stage. While you're building your nest egg, you've got wiggle room: You can increase the amount you save, you can invest more aggressively and, of course, you've got time on your side.

But once you've retired and started pulling money out of your portfolio, there's much less room for error. If the value of your portfolio sinks, you're not likely to have new savings to shore it up. And time is no longer your ally. To put it bluntly, the margin of error when managing your money during retirement is much smaller than during the accumulation stage. So you've got to be especially careful about the strategy you set and the decisions you make to carry it out.

There's no single strategy that works best for everyone. The approach you take will depend on such factors as how much money you've accumulated, how much income you need to draw from your assets to live on, how much will come from Social Security and other pensions, how much you plan on leaving to your heirs (deserving and undeserving), your estimate of how long you'll live and how concerned you are about outliving your money.

I'll be the first to admit that things can get complicated in a hurry. But the drawdown phase is manageable if you're willing to set a thoughtful strategy, monitor it and make adjustments along the way.

One more thing before we get into the nuts and bolts: If you're under age 50 and retirement still seems like a far-off mirage, you may be tempted to blow off this concern. Why worry about converting assets to income when your main focus is building assets and investing them for the future? Think again. The accumulation and withdrawal phases of retirement planning are inextricably linked. The sooner you come to grips with the fact that living off your retirement savings for a span of three decades or more may be more difficult and require a larger stash than you think, the more incentive you'll have to save now. It's a rude awakening to find on the eve of retirement that the 401(k) balance that once seemed so huge won't go nearly as far as you expected.

When you're accumulating money for retirement, you're probably aware that you're taking on investment risk—that is, exposing yourself to the possibility that your stocks, stock funds, bonds, bond funds and other investments might lose value. What many people don't recognize, however, is the additional dimension to risk in the drawdown phase of retirement planning: longevity risk. Basically, this is the all too real possibility that you'll outlive your money—that you may run through your retirement stash before you pass into the great beyond, leaving you to live out your golden years in a less than golden fashion. And even if you're aware of this risk, chances are you greatly underestimate it, much as investors misjudged investing risk back in the 1990s.

One reason is that few of us have a real understanding of life expectancy statistics, so we underestimate just how long our retirement portfolio is going to have to support us. And if your portfolio will be supporting another person as well, it's got to last even longer. One of the peculiarities of actuarial calculations is that the odds of at least one member of a couple being alive at some point in the future are higher than the odds of either person alone. While a 65-year-old man has a 30% chance of living to age 90 and a 65-year-old woman has a 41% chance of hitting that age, the odds are nearly 60% that at least one member of a male-female couple both age 65 will be around at 90. All of which is to say that unless you've got a fatal condition or you have reason to believe that you're genetically programmed for a short life, you should expect that your assets will have to last a good 25 to 35 years after you retire. (You can see all this in living color in the chart on the facing page.)

This has some profound implications on a practical level. At the very least, it means that you've got to factor inflation into your withdrawal strategy. If you continue to withdraw the same dollar amount year after year from your portfolio, you will eventually lose substantial purchasing power. To be able to buy the same level of goods and services, you will have to increase the dollar amount you withdraw from your portfolio each year.

How big an increase you need will depend, of course, on the rate of inflation. But even at modest levels of inflation, I think most people would be surprised at how much their withdrawals would have to increase. For example, if you begin withdrawing $40,000 a year from your portfolio at age 65 and inflation averages 2% a year—lower than the average of 3% or so since the 1920s—then by the time you're 85, you'd need to withdraw just over $59,000 just to stay even. By 95, you'd need to withdraw more than $72,000. And if inflation came in at its historical 3% average, your annual withdrawal would have to top $72,000 at 85 and over $97,000 by 95—more than twice as much as your original forty grand.

Despite this harsh reality, many investors still seem to have the illusion that their retirement portfolios are bottomless pots they can dip into for relatively large sums of money for 30 years or even more. I suspect that the relatively high average returns we've had in financial assets over the past two decades have given us an inflated notion of what kind of withdrawals our portfolio can sustain without running dry. But basing a withdrawal strategy on average returns can be dangerous.

Let's assume you retired at 65 with a $500,000 portfolio, 60% of which is invested in large-company stocks and 40% in intermediate-term government bonds, and you want your retirement portfolio to support you for at least 30 years. Considering that even after the bear market that began in early 2000 large-company stocks delivered an annualized return of more than 12% for the 20 years through 2002, that intermediate-term bonds over that period returned roughly 9%, and that inflation averaged about 3%, you might assume that you could withdraw, say, 8%, or $40,000 a year, and increase that for inflation each year without having to worry.

The reality: If you had embarked on exactly this strategy at the end of 1972, you would have run out of money in less than 10 years, or before you turned 74. Even if you had lowered your withdrawal to just 5%—an initial withdrawal of $25,000—the money would have been gone in just under 21 years, when you would have had almost a 50% chance of being alive and kicking for years to come. (See the chart below.)

Why did that happen? Because of a little thing known as the 1973-74 bear market, which knocked the stock market for a 43% loss. That enormous loss so early in the period combined with the inflation-adjusted withdrawals to put such a big dent in the portfolio that it wasn't able to recover in time to participate fully in the bull market that began in August 1982.

The single most effective thing you can do to ensure that your money will last is to start out with a low withdrawal rate, probably on the order of 4%, then raise that amount annually to compensate for a cost-of-living increase or inflation.

I'm sure most people would expect to be able to get more than $20,000 a year (before taxes) from a $500,000 portfolio. Tilting your portfolio mix toward stocks can somewhat improve the chances that you won't outlive your funds. But even with an all-stock portfolio, the odds of running out of cash with an initial withdrawal rate of 7% that's adjusted for inflation are more than 50%.

You've also got to remember that the higher the concentration of stocks or stock funds in your portfolio, the more its value will drop during market setbacks. I'm sure many retirees who entered the bear market of 2000 with 80% or more of their portfolio in stocks probably wish they'd played it a bit more conservatively. In short, by setting a low initial withdrawal rate, you can get decent odds of your money lasting through a long retirement without having to accept the huge ups and downs you would experience with an all-stock portfolio.

As I've said before in the pages of this magazine, there is a way to virtually ensure you'll always have money coming in no matter how long you live, and that's to buy an annuity.

To recap my argument, when it comes to converting assets into a steady income stream, annuities can play a valuable role. Although they can get brain-numbingly complex, the basic premise of annuities that make regular payments—known as payout or immediate annuities—is pretty simple. Basically, they work like a life insurance policy in reverse. Instead of making regular premiums to an insurance company that pays a lump sum upon your death, you give the insurer a lump sum of cash in return for regular income for a specific period, or until you die (with what is called a life annuity).

An annuity offers more than just a guaranteed lifetime income, however. It also allows you to draw a higher annual income from your assets than you could manage on your own, even if you earned the same rate of return. How is that possible? The answer is that while you must base your payments on a single life—your own—insurers can base annuity payments on a pool of thousands, in some cases millions, of people. And they know that while some of these people will survive to their life expectancy and beyond, many others will die earlier. So insurers can boost their payments by, in effect, transferring the money of those who die early to those who die late. To make that transfer possible, annuity buyers must agree to give up access to their original investment. (Some annuities may give you access to your money or even allow your heirs to collect something if you die, but such annuities make lower payments.)

The size of the payments you receive from an annuity, how long you get them and whether your heirs collect from the annuity after your death all depend on what kind of policy you choose—a fixed-payment annuity or one with a variable payment that fluctuates with the market but offers the possibility of a rising income over time. To see how these options work, see the table on the next page.

Many annuities come with features designed to enhance their sales appeal. Some promise to increase payments with inflation, for example; others guarantee that your payments won't drop below a specified minimum. Such bells and whistles may make you feel more comfortable—but they aren't free.

Fortunately, there is a simple way to take advantage of annuities without, on the one hand, paying too much for extra features or, on the other, giving up access to all your retirement assets.

That solution: Invest a portion of your retirement portfolio in one or more low-cost annuities with no expensive options, and keep the rest of your money in a portfolio of mutual funds and/or stocks and bonds that you can draw from as needed.

How much money should you consider investing in one or more of the annuities in this hybrid plan? There are no guidelines that can lead you to a "correct" percentage. I can't imagine a scenario where it would make sense to annuitize all your assets; that would be placing too large a bet on one investment and limiting your flexibility for dealing with life's unanticipated financial demands. In fact, you may not need an annuity at all if you've accumulated so much wealth that the chances you'll last longer than your assets are minuscule.

Between those extremes, however, deciding the percentage that's right for you depends on a variety of factors: how much you've saved, how much income you want in retirement, how long you think you're likely to live, how concerned you are about running short and how much money you'll need on hand for unexpected expenses and such. The greater your chances of living a long life and your concern that you might outlive your money, the more of your assets you would want to devote to annuities.

One approach is to cover as much as possible of your essential living expenses (food, clothing, housing, medical care and so on) with Social Security, company pensions and annuities, and then rely on withdrawals from the rest of your portfolio for discretionary spending and emergencies. All in all, I think it would be reasonable for most people who decide they need the stability of a reliable life-time income to consider devoting 25% to 50% of their retirement assets to a combination of fixed- and variable-payout annuities.

To get the biggest retirement paycheck, you must do two things. First, annuitize your money in chunks over a few years. Don't do it all at once. The payment you get from a fixed-payout annuity depends largely on current interest rates, so if you put all your money into an annuity when rates happen to be very low, you've relegated yourself to a lifetime of low payments.

Second, manage withdrawals from outside the annuity portion of your portfolio so that as little as possible gets siphoned off by the IRS and state tax authorities. Generally, you have the best chance of minimizing the tax bite and leaving more money for you by following these guidelines.

• Draw from your taxable accounts first. If you hold investments such as mutual funds, stocks, bonds and CDs in taxable accounts, it's likely that they are regularly throwing off some sort of taxable gains in the form of dividends, interest payments and, in the case of mutual funds, capital-gains distributions. You're already paying tax on them, so you may as well spend them. And if you hold on to them, they'll continue to generate taxable gains.

Keep in mind that not all your assets in taxable accounts are equally vulnerable to taxes. Municipal bonds, for example, generate interest that is free from federal taxes and, in some cases, state taxes as well. Individual stocks and certain types of mutual funds (index funds and tax-managed funds, for example) can also be tax efficient, in that their returns come mostly in the the form of an increasing share price; your gains aren't taxed until you sell.

Those gains are also taxed at lower long-term capital-gains rates as long as you hold the stock or fund longer than a year. Dividends are tax efficient in the sense that they're now taxed at the same lower rate as long-term capital gains. But you have no control over when the dividends are paid out to you. Most companies pay them quarterly, which means you'll owe tax on those dividends every year.

So when drawing from your taxable accounts, look first to the investments that generate the biggest tax bills and then move on to more tax-efficient assets, such as muni bonds, as well as individual stocks and index and tax-managed mutual funds in which you've built up large long-term capital gains.

• Move on to tax-deferred retirement accounts. It pays to avoid tapping tax-deferred accounts first, if possible. The reason: Those accounts can grow more quickly since the gains aren't being eroded by taxes. Keep in mind, though, that at some point the government requires that you start pulling money out of tax-deferred retirement accounts such as 401(k)s and IRAs (but not Roth IRAs). And if you don't withdraw the right amount, you can be hit with some staggering penalties.

Your withdrawals from these accounts will be taxed at ordinary income tax rates, with one exception: If you made nondeductible contributions to your IRA (or to a 401(k) that was then rolled into an IRA), only the gains on those contributions are taxable.

• Save money in a Roth IRA for last. There are several reasons to hold off as long as possible on tapping assets in Roth accounts. First, once you're over 59½ and the money has been in the account for at least five years, all withdrawals from your Roth accounts are tax-free. Second, unlike traditional IRAs, Roths have no required withdrawals. You can let the money rack up tax-free gains in the account as long as you want. Finally, Roth IRA assets can be passed along to your heirs free of income tax.

Of course, your circumstances might lead you to draw down your assets in a different way. For example, if your retirement savings are so large (or your income need in relation to your assets so small) that it's unlikely you'll deplete your portfolio in your lifetime, you may want to spend tax-deferred assets first. You're probably better off leaving your heirs stocks or mutual funds held in taxable accounts, since the cost basis of those assets steps up when you die. That means your heirs pay taxes on only the gains earned after they inherit, not on the unrealized gains that accumulated during your lifetime. If you expect to leave a sizable estate—certainly anything over $1 million—it's worthwhile to consult an estate-tax attorney or financial planner who deals in such issues.

It's also possible that you may fall into an unusually high income tax bracket in some years. Then you may want to sell stocks from a taxable account to produce gains that will be taxed at lower long-term capital-gains rates; you may even consider taking tax-free withdrawals from your Roth IRA. Or there may be opportunities to play the tax code by selling stock or funds in your taxable account at a loss to offset other gains. But before you sell securities for tax reasons, take a look at IRS Publication 550, "Investment Income and Expenses" (available at irs.gov).

Ultimately, your goal once you've finally retired is to ensure that the resources you've built up during your career—your Social Security, your pensions, your investments—support you in retirement as well as they can for as long as they can. At the same time, you don't want to spend every minute obsessing about your finances and agonizing over every investment move. Retirement is supposed to be a time when you enjoy life, a chance for you to do some of the things you didn't have time to do during your working days.

By all means, take the time to plan, monitor your progress and make appropriate adjustments to your plan so that you can attain a good measure of financial security. But remember that retirement planning is a means, not an end. Don't let the planning get in the way of living a happy and fulfilled life. You get only one retirement. Enjoy it while you can.

Notes: [1] Also available with 1%, 2%, 4% or 5% increases; the higher the annual adjustment, the lower the starting payment. [2] Initial payments can be higher if survivor accepts lower payment. [3] Initial payment is based on an assumed interest rate of 3.5%.

SOURCES: WebAnnuities.com, Ibbotson Associates.