How to Make the Nest Egg Last?

What return or yield do you need to make your nest egg last? How much can you safely withdraw from your retirement fund? Those are the key questions of retirement, because no one wants to run out of money. More people are asking these questions since interest rates settled near their lowest levels in decades and the stock market has been treading water for six months.

Most people probably would prefer to put their nest eggs in treasury bonds and live only off the interest payments. But you know why that is not safe, unless you have a large fund. Inflation will eat away at the value of your income and principal, and you’ll end up much poorer than you started.

Almost everyone should be investing at least part of his or her nest egg for growth. Then, you sell some of the fund to pay living expenses as needed.

But you also take risks when investing for growth. The value of the principal will fluctuate as the investments fluctuate. Over the long term, we all know that doesn’t matter. The stock market will increase by about 10% annually. Spend less than that, and you’ll never need to touch the principal.

But the real world isn’t that simple. The risk is that the stock market might begin an extended decline or a long period of low returns shortly after you begin this program.

Suppose you retired in 1966, at the peak of the stock market until 1982. Inflation was rising, meaning the cost of everything increased. In 1973-1974 the stock market indexes lost about 50% of their value. If you retired in 1966 with half your portfolio in stocks and withdrew 5% of the portfolio’s original value each year, you would be out of money after 18 years.

To make your money last at least 30 years in that situation, if your portfolio is equally balanced between stocks and bonds, your annual spending cannot exceed 4.1% of your portfolio’s first year value. After the first year, you can increase the payout each year to keep up with inflation. After taxes, if your money is in a tax-deferred retirement account, you’ll have 3.5% of the account to spend. If less than half the portfolio is in stocks, then you can safely withdraw less than 4.1%.

Now, here’s the good news. That is the worst case scenario, assuming a repeat of the 1966-1982 market and economy shortly after you retire. If the 1966-1982 scenario doesn’t repeat in your lifetime (and I think it is unlikely to recur), you’ll be able to withdraw 5% or more of the fund each year. Also, the 4.1% withdrawal rate is designed to make your money last 30 years. If you don’t think you’ll live 30 years in retirement and don’t care about leaving a lot for your descendants to inherit, you can withdraw more than 4.1%.

The 4.1% withdrawal rate also assumes the portfolio is invested in the S&P 500 and intermediate bonds. You could mix in some small stocks and international stocks. Historically, this increases your long-term returns. You also might shift some of the bond investments from intermediate bonds to short-term bonds or money market funds. That reduces losses if inflation returns.

Another positive consideration is that most people naturally reduce their spending as they get older. They simply aren’t as active, so they don’t travel as much or play as much golf. So, you can spend more in the early years, knowing you’ll spend less than in later years.

Most studies indicate that you can safely withdraw 5% annually from a diversified portfolio of stocks and bonds without running out of money for 30 years or more. If you don’t hit a rough patch like 1966-1982, you can spend a little more than 5%, or spend the 5% and have much more money than you started with.

Another way to approach this question is to with a new type of computer calculator that uses actual year by year historic returns to determine the probability of achieving your retirement goals. Not too long ago you needed a supercomputer to do this.

To get these calculations for your situation, you can go to the web sites www.financial-engines.com or www.financialplanauditors.-com. Each site charges a fee for this service. Mutual fund company T. Rowe Price will perform the calculations as part of its Retirement Income Manager service for $500. These computation generally show that you can withdraw 6% to 7% annually with a 90% probability of not running out of money.

The bottom line is that you are almost never too old to have stocks in your portfolio. You’ll need the growth, and you can find ways to deal with the risk. Here are some more ways to handle the risk of having stocks in your portfolio:

• Have fixed expenses of no more than 5% of your initial portfolio value. Then you can spend more as long as things go well. If the portfolio takes a tumble, cut back on travel and other optional expenses for a year or two.

• Keep a couple of years’ fixed spending in a money market fund. That way you won’t have to sell depressed stock shares in a bear market. You can draw from this reserve fund while waiting for the stocks to recover.

• Keep seven years of spending in bonds. This gets you through a longer bear market without selling depressed stocks.

• Use fixed annuities as a floor on your portfolio. The value won’t fluctuate with interest rates or the stock market, and the income is guaranteed by the insurer. The risks are that the insurer might have financial problems, and inflation will eat away at the purchasing power of the guaranteed income.