How Much of Their Nest Egg Should Retirees Spend a Year?

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John Kuczala
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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How Much of Their Nest Egg Should Retirees Spend a Year?
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Once your children are independent, you will likely no longer need a several-bedroom house in a good school district with a large yard that can be expensive to maintain. Consider downsizing to a smaller home in a less-expensive neighborhood, and add the proceeds of the sale to your nest egg.
Where you live plays a big role in how much you pay for food, taxes and a variety of other services. Moving to an area where the cost of living is significantly less could allow you to spend down your retirement savings more slowly.
If you and your spouse commuted to separate places each day, it is likely that you each needed a car. In retirement, you might be able to get by with one car, thus eliminating the insurance, gas and maintenance costs of the second vehicle. In walkable communities with good public transportation, you may even be able to get by without a car in retirement.
In retirement, income tax will be due on withdrawals from traditional 401(k) and individual retirement accounts, but you can space out your withdrawals to avoid a hefty tax bill in a single year. Prepaying income tax on some of your retirement savings using a Roth IRA or Roth 401(k) allows you to avoid a big tax bill in retirement.
Investing in high-cost funds reduces your return. Minimizing investment costs is especially important for retirees who are living off income from their portfolio. In this case, selecting the lowest-cost funds that meet your investment needs translates to more money in your pocket.
There are significant penalties if you withdraw money from your retirement account too soon or too late. There is also a reduction in benefits if you sign up for Social Security early, and a late enrollment penalty if you delay signing up for Medicare Parts B and D. Pay attention to important retirement deadlines to avoid paying more than you need to.
Health care is likely to be one of the biggest and least predictable costs you will face in retirement. But there are some things you can do to control your health costs. Consider purchasing a supplemental policy to Medicare to fill in some of the gaps and cost-sharing requirements traditional Medicare doesn't cover. Also, shop for a new Medicare Part D plan every year to make sure you are getting coverage for your medications at the best price.
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