Will you outlive your nest egg?

By Lynn O'Shaughnessy

Not if you save diligently now and follow these investment and withdrawal strategies when you retire.

As you prepare for retirement, perhaps the hardest question you'll ponder is this one: How much money will I be able to withdraw from my nest egg each year without emptying it?

Finding the right answer is critical. But if you rely upon conventional wisdom to develop a withdrawal strategy, you could end up draining your portfolio faster than you ever imagined.

Many people mistakenly believe that they can skim off just a tad less each year than they expect their nest egg to generate. For example, you might assume that it's safe to withdraw 7 or 8 percent from a portfolio of 60 percent stocks and 40 percent bonds that has returned nearly 9 percent annually for decades. But research has shown that this approach can prematurely deplete your portfolio, if you aren't watching carefully. This would be especially true if a bear market strikes during the early years of your retirement.

To illustrate, T. Rowe Price, the mutual fund firm, examined what would have happened to a hypothetical $250,000 nest egg between 1968 and 1998, a period that included the ferocious bear market of 1973-74. During that 30-year stretch, the portfolio, which contained 60 percent stocks, 30 percent bonds and 10 percent cash, would have produced an 11.7 percent annualized total return. But if an individual had pulled out 8.5 percent in 1968 and then increased future withdrawals 3 percent annually for in- flation, the money would have vanished in less than 13 years. The double whammy of poor stock performance in the early years and an overly gen-erous withdrawal rate would have crippled the portfolio.

To preserve your future, think small

So what's the solution? Because no one can predict the stock market's behavior, many financial planners have embraced an approach from a landmark study by William Bengen, a financial planner in El Cajon, CA. Using historical data dating back to the 1920s, Bengen concluded that a low withdrawal rate can shelter a portfolio through truly ugly bear markets. If you want your money to last 30 years—the number that financial planners typically use to reflect today's longer life expectancies—you probably shouldn't take out more than 4 percent the first year, says Bengen. After the first year, you'd adjust the annual withdrawal amount for inflation.

Of course, you don't need a calculator to figure out that following Bengen's advice will require a considerable stockpile of cash. "In order to replace a very large income and continue the standard of living a physician could be accustomed to, it's going to take millions of dollars," observes Christine Fahlund, a financial planner at T. Rowe Price. "Generally, you need to have saved $1 million to have $40,000 to spend in your first year of retirement."

If your calculations suggest that you'll come up short at your current rate of savings, you could vow to save more or reduce your spending in the years leading up to retirement. Or try both approaches, Fahlund suggests. "It would be wise to start examining your lifestyle when you're 50 or so and begin to look for ways to cut back, so you've pared down to something workable by the time you do retire."

Once you stop working, you'll also need to pay careful attention to how your portfolio is invested. Again, following conventional wisdom, which urges retirees to invest heavily in bonds, could imperil your portfolio's long-range prospects. Based on his series of retirement studies, Bengen suggests that retirees should invest 50 to 75 percent of their assets in stocks, with the rest in bonds. Only stocks, he explains, offer the growth potential that can keep a portfolio chugging along for 30 or more years. In fact, he says, a retiree who doesn't keep at least half of his or her portfolio in equities would have to pare down the recommended 4 percent initial withdrawal figure even further.

Other financial researchers also warn against relying too heavily on bonds in retirement. Another landmark study, conducted by professors at Trinity University in San Antonio, TX, concluded that a retiree who invests in an all-bond portfolio and withdraws 5 percent a year would have only a 17 percent chance of having any money left after 30 years. In contrast, a portfolio split evenly between stocks and bonds would provide a 76 percent chance. An overabundance of bonds takes an even bigger toll when future withdrawals are increased to keep pace with inflation (see "Finding the right balance in retirement").

Maybe you wouldn't feel comfortable sitting on a stock-heavy portfolio as you head into your later retirement years. While Bengen thinks it's best to stick with the original asset allocation, he says reducing a portfolio's stock exposure a bit below 50 percent shouldn't severely jeopardize your nest egg.

On the flip side, if you're in your late 70s or 80s and hope to leave family members a bigger inheritance, you might continue to embrace stocks. At that age, Bengen observes, "It's a judgment call. You're not looking to get 30 years out of your money unless you're Methuselah."

Get an insurer to share the risk

Another way to hedge against outliving your portfolio is to sink a portion of your money into a fixed immediate annuity. This way an insurance company takes on the responsibility for making sure the money doesn't vanish. As the name suggests, an immediate annuity begins payouts right away. You're guaranteed monthly checks for your lifetime—or if you name your spouse as a joint annuitant, for both of your lifetimes—even if your initial investment eventually is depleted. Part of each annuity check escapes income tax, because it represents the return of a portion of your premium.

The amount you receive monthly depends upon such factors as your age, gender, and the amount you invest. The older you are, the more generous the check.

A study by TIAA-CREF, which operates one of the nation's largest private pension systems, suggests that the odds of outliving your portfolio drop—sometimes quite significantly—with a fixed immediate annuity. Conservative in-vestors leery of loading up on stocks in their golden years could particularly benefit, the study concludes. For instance, a conservative portfolio (50 percent bonds, 30 percent cash, and 20 percent stocks) faced a 67 percent chance of being depleted within a 30-year period if a 4.5 percent withdrawal rate was used. But if stocks, bonds, and cash made up only 50 percent of the portfolio and the other half was invested in an annuity, the depletion risk dropped to less than 19 percent.

"A fixed immediate annuity can make retirees feel more comfortable diversifying a port- folio, because they have an income stream they can count on," observes John Ameriks, a senior research fellow at the TIAA-CREF Institute.

But keep in mind that once you invest in an immediate annuity, you can't get out of the deal. Also, the monthly payments won't be adjusted for inflation, so even if they're sufficient now, they may not be in 20 or 30 years. The size of the payments can vary significantly among issuers, too, so be sure to check with several before you hand over your cash. Finally, be sure the issuer is financially stable by checking its rating in a source such as Moody's Investors Service or Weiss Ratings.

However you decide to structure your portfolio after quitting medicine, it pays to plan ahead. Making snap decisions could jeopardize the prospects of living the kind of retirement that you probably began dreaming about in med school.

Finding the right balance in retirement

How can you best ensure that your retirement kitty will last as long as you do? History suggests you should favor stocks over bonds and keep annual withdrawals modest. Stocks carry considerable short-term risk, of course, as the past few years have clearly shown.

The table below shows the odds that your stash will last for 30 years, given different investment and withdrawal mixes. For instance, say you invest 75 percent of your funds in stocks and 25 percent in bonds. The year you retire, you withdraw only 4 percent of your savings, and in future years you increase withdrawals only enough to keep pace with inflation. Assuming historical securities patterns continue, you can be 98 percent certain that your cash will last 30 years.

Lynn O'Shaughnessy is a freelance financial writer in La Mesa, CA, and the author of Retirement Bible.

 

Lynn O'Shaughnessy. Will you outlive your nest egg?. Medical Economics May 9, 2003;80:41.