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Scared to outlive nest egg? Find the right withdrawal rate

As any financial planner can attest, it isn't only how much is saved but what is spent that determines whether a nest egg will last.

Indeed, the annual withdrawal rate during retirement is the most important factor in minimizing the likelihood of outliving one's money.

That percentage, which differs for everyone, is based upon the amount socked away; age at the time of retirement; sources of guaranteed income, such as pension and Social Security; and annual living expenses.

Percent button on calculator
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But the so-called "4 percent rule" has long been used as a starting point for retirement-planning purposes.

The rule suggests that a retirement portfolio invested equally (50/50) in stocks and bonds will last 30 years if the account holder withdraws 4 percent of savings the first year of retirement and adjusts that amount annually by the rate of inflation.

Assuming portfolio returns of, say, 10 percent, such a strategy would allow retirees to spend just a portion of their earnings and preserve principal.

Guarding against paltry yields

Yet the markets can be volatile, as was the case following the dot-com collapse in 2000, the housing crisis of 2007 and the Great Recession of 2008 and 2009.

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During those years, and some in between, the average mixed portfolio didn't earn 4 percent after bond exposure was factored in.

The S&P 500 Index returned 2.1 percent in 2011, 5.5 percent in 2007 and 4.8 percent in 2005. It lost 12 percent in 2001, 22 percent in 2002 and almost 37 percent in 2008.

Stocks, of course, have enjoyed an impressive rally since then, with S&P 500 returns of about 16 percent in 2012, 32 percent in 2013 and 13 percent in 2014, but income investors now face a different problem: bond yields.

The benchmark 10-year Treasury, which historically has served as a core holding for retirees, is hovering just under 2 percent, down from 9 percent in 1990.

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Against a backdrop of punishing losses and paltry yields, then, it is prudent to question whether the 4 percent rule remains valid.

The answer depends on asset allocation, time horizon and portfolio costs.

"There's a lot of worry about being able to take 4 percent in this environment, and it really depends on how you're invested," said Maria A. Bruno, a senior investment analyst with Vanguard Investment Strategy Group. "We advocate a total-return investment approach, regardless of what stage of investing you are in."

A balanced retirement portfolio that is split between equities and fixed income (50/50 or 60/40) and adequately diversified among asset classes should allow for growth, despite ultra-low bond yields, Bruno said.

Thus, "the 4 percent rule is still a reasonable starting point," she said.

A recent study by T. Rowe Price confirmed that.

After examining returns for a diversified portfolio of 60 percent stocks and 40 percent bonds over rolling 30-year periods beginning in 1926, the study found that a 4 percent initial withdrawal rate could be sustained for 30 years with a 90 percent probability that the investor wouldn't run out of money, regardless of the value of stocks and bonds at the investor's time of retirement.

"From our point of view, the 4 percent guideline—and it is only a guideline—still holds up," said Judith Ward, a certified financial planner and senior financial planner for T. Rowe Price.

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Investors who allocate more conservatively, with a larger percentage of bonds, of course, may need to reduce their withdrawal rate accordingly, she said.

Those who retire early or begin depleting their personal savings on day one of their retirement, with minimal Social Security, pension payments and other sources of guaranteed income, may also need to ratchet back.

Conversely, older retirees in their 70s or 80s, who are just starting to dip into their personal savings, may be able to adjust their withdrawal rate higher.

When calculating a sustainable withdrawal rate, according to Bruno at Vanguard, it is important to note that taxes and investment fees contribute greatly to nest egg erosion.

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Thus, higher costs equal a lower allowable spending rate.

According to Vanguard's research, a hypothetical moderately invested portfolio absent any costs would last at least 30 years, 86 percent of the time using the 4 percent rule.

The same portfolio that surrendered 25 basis points to investment fees produced an 84 percent success rate, a negligible drop, but a higher cost portfolio (125 basis points) would go the distance just 74 percent of the time.

"A portfolio that is cost- and tax-efficient stands a far better chance of long-term success," Bruno said.

"You don't want to run out of money, but some clients end up being overly frugal just to leave an enormous nest egg for their heirs." -Stein Olavsrud, certified financial planner with FBB Capital Partners

In determining how much they can safely spend, Stein Olavsrud, a CFP with FBB Capital Partners, said that many retirees forget the goal: It isn't merely about preserving a nest egg but using hard-earned savings to live life to the fullest.

Leaving a financial legacy to children is a noble goal, but not if it negatively affects quality of life, he said.

"Keep in mind that the 4 percent rule could potentially leave someone with an abundance of assets in their later years," Olavsrud said.

"You don't want to run out of money, but some clients end up being overly frugal just to leave an enormous nest egg for their heirs," he said.

Be flexible about 4 percent

It is worth noting, too, that the 4 percent rule is designed to be flexible, said Erik Dullenkopf, a CFP with MetLife Premier Client Group.

Retirees may need to take a slightly higher percentage for a year or two to cover medical expenses, retrofit their home or pay for a dream vacation, but they would be "encouraged to get back on track the next year," he said.

To minimize the risk of prematurely depleting their savings, investors might also pursue the alternate strategy of denying themselves an inflationary raise following a bear market.

The 4 percent spending guideline remains intact for retirees who stay diversified, contain their costs and consider their time horizon, Bruno at Vanguard said.


—By Shelly Schwartz, special to CNBC.com