If you're among those fortunate enough to have saved enough to retire comfortably, you'll still face this annual dilemma: How much of that stash can you spend each year?
There are more than 76 million baby boomers in the United States, and they'll be retiring at a rate of about 3 million a year. That makes the hopes, dreams and fears about retirement a top-of-mind issue for about a quarter of the U.S. population.
The average life expectancy for someone turning 65 this year is an additional 20.4 years. Now, those life expectancy tables can tell you how long the average person will live, but they don't speak to the downsides of living an unusually long life. While it's a blessing to live into your 90s or even longer, it also means there's a greater chance that you will outlive your savings. And that great unknown -- how long will you live? -- is at the root of our fears when it comes to planning how to spend money in retirement.
Let's examine some of the most-discussed strategies for calculating a spending plan that won't have you outliving your next egg, including the 4 percent rule, annuities, required minimum distributions and living only on dividends and interest.
The 4 Percent Rule
The 4 percent rule is one of the most commonly recommended approaches: The idea is to spend 4 percent of your assets each year, adjusted for inflation.
That's a "safe withdrawal rate [that] actually has a 96 percent probability of leaving more than 100 percent of the original starting principal," according to Michael Kitces, publisher of the Kitces Report blog and partner at Pinnacle Advisory Group in Columbia, Maryland.
The 4 percent formula is based on an allocation of 60 percent stocks and 40 percent bonds. But with bond interest rates near all-time lows, does this still hold up? Kitces says it does "because historical safe withdrawal rates aren't based on historical averages. They're based on historical worst-case scenarios."
In fact, he says that if you could be sure that markets would produce "average" returns over the course of your retirement, the safe withdrawal rate would be closer to 6.5 percent.
This strategy requires you to rebalance your portfolio each year to maintain the 60/40 balance. Kitces says this will help you avoid selling stocks in a down market. If stocks declined, you would raise the necessary cash distribution by selling bonds instead, which would also bring your portfolio back into balance.
Annuities as an Alternative
But the 4 percent rule has plenty of critics. Part of the problem is that its success hinges on the timing of when you retire. If you leave the job market just before the stock market goes into a tailspin, you could be in trouble, argues Anthony Webb, research economist at Boston College's Center for Retirement Research. He calls the rule "a foolish thing" that gives its adherents a "very high probability of running out of money."
Webb says people need to tailor their withdrawals to market returns, cutting back on spending when the market does poorly. He says stocks have a higher expected return over the long term, but with considerably higher risk -- "and you really have to build that risk into your plan."
Webb suggests that inflation-adjusted annuities will take the longevity risk off the table for most people. However, annuities require a significant up-front investment that could limit your financial flexibility, and they could reduce the inheritance you intend to leave, because most annuities expire upon your death. "I know people will say you're gambling with death, but the fact remains that unless you're super-rich, that's the only way to insure against longevity risk," asserts Webb.
Required Minimum Distributions and Other Ideas
Another strategy is based on the required minimum distributions set by the Internal Revenue Service. The IRS rules require that those of us with 401(k)s or other retirement accounts to begin to draw down those assets starting no later than age 70½. The percentage of mandatory withdrawals starts low and increases as you age. Some financial advisers say sticking to those minimums can be an effective strategy for many retirees.
Some retirees want to live only on the dividends and interest earned by their investments, and keep their principal intact. This strategy can work for people with substantial nest eggs, but experts warn that it could prompt some people to make poor investment choices in the name of boosting their dividend and interest income, at the detriment of their portfolios' long-term growth.
Other factors to consider in deciding what strategy to use include when you decide to start collecting Social Security (most advisers suggest delaying as long as you can to get the biggest monthly benefit), your health, and your tolerance for risk. And then there's the psychology of spending the money you've worked so hard to save. "Savers who have accumulated wealth have to get themselves out of the savings mode and into the spending mode," said Webb. "It really is OK. It's not morally wrong. It's what you saved for in the first place."
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