After spending your whole career trying to save up enough money for a comfortable retirement, retirees face a brand new challenge: how to make their investment portfolio last a lifetime.
Most financial advisers believed that they had a simple answer to that tough question, but recently, the rule they came up with has come under fire for potentially being too risky. Let's take a look at the controversial "4-percent rule" and why critics have attacked it recently.
Understanding the 4-Percent Rule
In terms of simplicity, you can't really beat the 4-percent rule. How it works is that you take your total portfolio value when you retire and multiply it by 4 percent. The resulting figure gives you your annual income. The following year, you take the previous year's figure and then adjust it by whatever the inflation rate was during the previous year.
The result is that you should be able to sustain the same purchasing power throughout your retirement.
When 'The Rules' Don't Work
The 4-percent rule has been around for a long time and was based on actual performance in the stock, bond and other financial markets. Yet as analysis from mutual-fund giant T. Rowe Price shows, retirees who retired in 2000 with their investments split 55/45 between stocks and bonds and who followed the 4-percent rule saw their portfolios lose a third of their value by the end of 2010.
Looking forward, even bigger concerns exist.
With both the stock market and the bond market at relatively high price levels, a paper earlier this year from two professors and an investment professional at Morningstar (MORN) found that an extended period of low investment returns could sabotage the 4-percent rule, with failure rates exceeding 50 percent under certain circumstances. In particular, the paper, "The 4 Percent Rule Is Not Safe in a Low-Yield World," focused on low interest rates that dramatically sapped the income-producing potential of the bond portion of portfolios.
Turning to the IRS for Help
Rather than using the 4-percent rule, one alternative looks at a rate that the IRS uses to determine how much money retirees have to take out of IRAs and certain other retirement-plan accounts.
In order to prevent investors from keeping money in traditional IRAs and 401(k)s forever, the IRS has rules governing required minimum distributions each year that take effect when you turn 70½. Essentially, you're required to take out a fraction of your total retirement-account balances every year. That amount is based on the expected number of years remaining in your lifetime. An IRS publication provides the appropriate life-expectancy table.
Compared to following the 4 percent rule, using the IRS tables results in smaller withdrawals in the early years of retirement. For example, the rate for a 62-year-old equates to a roughly 3-percent withdrawal. Only once you reach age 73 does the withdrawal go above 4 percent, and there are no automatic upward adjustments for inflation -- the only boost comes if your portfolio value increases.
The IRS-table method has advantages and disadvantages.
On one hand, unlike the 4-percent rule, it's mathematically impossible to run out of money using the IRS-table method, as each year's withdrawal is based on the remaining value in the portfolio rather than the first year's value. The IRS-table method also lets retirees benefit from increases in the market value of their assets. Yet it leaves retirees exposed to big drops in allowed withdrawals if their investments suddenly lose value.
Handling Retirement Risk
Without knowing the future, it's impossible to know whether any given method for drawing down your retirement savings will work best. Under some conditions, the 4-percent rule will work fine; in others, using the IRS-table method will give you better results.
What's really important, though, is to understand the principles behind the different rules.
The 4-percent rule shows that in most situations, ignoring market noise and making consistent withdrawals is perfectly safe. Yet the IRS-table method proves the value of being flexible enough in your finances to handle falling income levels -- at least temporarily.
Using the principles behind both rules can put you in the best position to retire comfortably no matter what happens in the markets.
You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google Plus.
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