Retirement Withdrawals: Make Your Money Last a Lifetime

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Last Updated Jul 29, 2009 11:11 AM EDT

Building up a nest egg is a tough financial assignment — no doubt about it. But when it comes time to actually live off those savings, you might realize how easy you had it when you were working. As a retiree, you have to decide how much you can draw down your savings each year in the face of such unknowables as how long you'll live, how much inflation will eat away at your assets, and how your investments will perform. If you get it wrong, you can't just go back to work and make up the shortfall.

For years, financial advisers have answered this tough question with the 4 percent rule of thumb: Withdraw 4 percent of your portfolio in the first year of retirement. In year two, withdraw the year-one amount plus an inflation adjustment, and so on for the rest of your life. Simulations of thousands of possible investment and inflation scenarios by financial planner William Bengen suggested that the 4 percent solution gave you a 90 percent chance or better of making it through three decades without running out of money or having to reduce your standard of living.

But after last year’s free fall in stocks and bonds, many advisers concluded that this strategy might be too simplistic. Bengen’s number crunching, performed in the mid-1990s using nearly eight decades of market history, didn’t account for 2008, when so many portfolios lost 30 percent or more of their value.

So some advisers have begun telling retired clients to forgo this year’s inflation adjustment or to reduce withdrawals to less than 4 percent. Even Bengen has instructed his retired clients to trim their distributions until this market’s fog clears and the economy recovers.

Time to Fill Your Buckets?

As a result, many advisers now suggest an entirely different approach. It involves segmenting your nest egg into pools or buckets of income that match up with specific years of your retirement. Some 52 percent of financial advisers now use this targeted approach, according to Gallant Distribution Consulting, an advisory firm serving the financial services industry. And you can do it yourself.

The bucket strategy starts out much like the 4 percent rule. You begin by determining a conservative withdrawal amount for the first year of retirement (typically equal to 4 percent or so of your portfolio). But you next multiply that amount by the number of years you want guaranteed income (usually five to seven), adding an estimated annual inflation adjustment. Then you invest the portfolio in Treasuries or a money market account to ensure a guaranteed withdrawal rate you can live on for those five to seven years.

Either annually or as the original bucket nears depletion (depending on the performance of the markets), you replenish the bucket with safe investments to throw off enough income for the next period. You do this continually throughout retirement.

Every adviser has his or her own variation on the method, but they all aim to lock in your spending for longer than a typical bull and bear market cycle. With several years of spending ensured, you won’t have to let Wall Street booms and busts determine how you live from one year to the next. If stocks tank in one year, you’ll have enough squirreled away in your spending bucket so that an adviser might suggest skipping a year’s worth of replenishment to allow the market time to recover.

“It’s basically matching liabilities with assets,” says Rick Plum, director of wealth management for Raymond J. Lucia Companies, a San Diego advisory firm using this approach. Bengen finds the method intriguing. In fact, he recently ran market simulations using allocations similar to the bucket technique and found that the money would likely last 30 years.

The Two-Pool Method

One way to implement the new strategy is using the type of rolling five-year pool recommended by Stephen Huxley, professor of information and decision modeling at the University of San Francisco and co-author of Asset Dedication. “The 4 percent rule is a good start, but only a start,’’ Huxley says. Using a dedicated portfolio, monitoring its progress, and working with high probabilities of reaching lifetime goals are the drivers of his strategy.

Huxley’s system involves locking up five years of retirement income in Treasury bonds and investing the rest in stocks for growth. Each year, he takes the prescribed income amount out of the bond portion. At the end of a year, if stocks have risen, a year’s worth of income gets rolled from stocks into the bond portion. If stocks have fallen, no withdrawals are taken from the stocks portion, allowing the equity portion time to recover. In a prolonged bear market, retirees would adjust their withdrawals as needed. Through regular monitoring and tweaking, retirees could make necessary adjustments if their portfolios’ value falls below the amount they need in retirement.

The Three-Bucket Approach

To give yourself a bit more margin of error, you can segment your nest egg into three buckets. Here’s how Plum’s firm would use the three-bucket method for someone with a $1.5 million portfolio who wants to withdraw $60,000 a year.

Bucket 1 for income in years one through seven: Holds $420,000 (plus an amount equal to an agreed-upon inflation factor) in ultrasafe investments, such as short-term Treasury bonds.

Bucket 2 for income in years 8 through 15: Holds either indexed annuities, which offer guaranteed income with an upside potential if markets do well, or a balanced mix of stocks and bonds.

Bucket 3 for the long term: Holds the highest-risk investments, such as equities, commodities, and real estate.

Each year in retirement, another year’s worth of income for Bucket 1 is pulled from Bucket 2 or 3. The exact drawdown depends on how the markets perform, but the idea is to capitalize on up markets and avoid selling in down years.

This new thinking about retirement withdrawals argues for starting early — experts say at least five years before retirement — to plan the payouts. By beginning to shift your retirement portfolio five years before you stop working, you can lock in a year’s worth of retirement cash flow annually, and you’ll retire with a safety net you can count on.

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