Can Retired Investors Dip Into Principal?

Last Updated Jan 31, 2011 3:24 PM EST

One question I get a lot these days from retired investors is, can I afford to spend any of my principal? In short, yes, you can afford to dip into some principal. But you have to understand how much and from where.
  • Because retirement income management is so tricky, I've got to qualify all of this material with the suggestion that you get professional help in this area. There are some rough rules of thumb that are helpful for you to understand, but any distribution of principal will create a risk of running out of money. Because market returns are so volatile, you'll probably face periods where you're going to have to decide whether to tap into some principal. And you'll need a strategy that meets your unique risk profile.
All else being equal, it's better to spend only your income (interest and dividends) and capital gains in retirement. But sometimes, that's just not workable because you have capital losses (your stocks go down in value) and the income alone isn't large enough to meet your distribution needs. That's basically the situation we have today. Many retirees can't afford to live only on their income, and are looking at losses on the value of their stocks as a result of the continuing secular bear market.
  • If you haven't been keeping track, stock prices are still below the high they reached in October of 2007.
Let's assume that today you could generate 3% in interest and dividends in a balanced retirement portfolio of stocks and bonds, and you want to take a 5% distribution. If the stock market doesn't go up this year, then you're faced with trying to live on only 3% or taking out 2% from your principal to fill the gap.

In general, it's a reasonable strategy to take that 2% principal distribution and anticipate that at some point stock prices will go up to replace the principal that you took. There's certainly no guarantee this will happen, but it's a reasonable assumption.

An important part of this strategy, however, is not to take the distribution from your stock holdings. If you take it from your stocks, then you're selling them when they're down (not a good strategy) and you'll have fewer shares available to participate in pricing gains when the market eventually recovers. If you're going to spend some principal, it's usually better to spend it from a cash reserve or to sell some short term fixed income securities that have maintained their value.

But you have to be careful, because if you dip into principal for too long, then you could find yourself in a deep financial hole.

For instance, assume the stock market goes down for 5 years, and you've been taking 2% principal distributions to supplement your 3% of income. Now, you've now eaten up 10% of your principal. Plus, if your stock portfolio is still down in value, then your total portfolio would be down more than 10%. The more you had in stocks, the bigger the decline would be.

While there's no guaranteed strategy for retirement income success, when we study historical market cycles, we can see that once a portfolio declines by about 20% to 25% from its original starting value, and the investor continues to take distributions, the odds of running out of money during a 30-year retirement increase by a meaningful amount.

Now I can't tell you whether this will continue to be the case in the future, but since history is really all we have when it comes to understanding market returns, it would be a good idea to keep this 20% to 25% threshold in mind. If you're combination of market declines and distributions puts you close to that range, you'll want to seriously consider how much principal you can continue to take from the portfolio. If you find that you're digging into principal at more than 2% a year, it doesn't take long to hit these thresholds in a bear market.

By the way, the more income you can reasonably generate in retirement, the less you have to rely on principal distributions to make it all work. For instance, if you could generate 4% in interest and dividends, and wanted a 5% distribution, then you would only have to tap into principal at 1% if the price of your stocks didn't go up. Or you could decide to just live off that 4% until the markets recover. Don't neglect to consider income production in your portfolio when you're retired. It can be a portfolio-saver during bear markets.

Bottom line. Retired investors can take small principal distributions without significantly increasing the risk of running out of money, as long as their portfolios remain largely in-tact.

Above material does not constitute investment advice. Consult your individual financial advisor prior to making any decisions. Past performance is not indicative of future returns, and all investing involves the risk of loss.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.