Low bond yields have raised troubling questions about whether the 4% withdrawal rule still holds up. Here is what works, and what doesn't, when it comes to stretching a retirement nest egg. By Eleanor Laise, Associate Editor From Kiplinger's Retirement Report, April 2013 Retirees relying on a popular strategy for drawing money from their portfolios may find the well running dry far sooner than expected. It may be time for them to find a more reliable approach to tap their savings.See Also: QUIZ: Are You Saving Enough for Retirement? Many retirees and financial advisers use the "4% rule" to calculate how much to spend from a portfolio each year in retirement. The rule is simple: Retirees who spend 4% of their initial wealth from a balanced stock-and-bond portfolio, adjusting the dollar amount annually to keep pace with inflation, can be highly confident that their portfolio will survive 30 years. But researchers lately have raised troubling questions about whether the 4% rule holds up under today's market conditions. Much of the academic research supporting the rule is based on long-term average returns for stocks and bonds. As retirees know all too well, today's bond yields are anything but average. Intermediate-term government bonds delivered average annual returns of 5.5% between 1930 and 2011, according to Morningstar's Ibbotson Associates, but yielded less than 1% at the end of 2012. Those low yields may mean parched conditions for retirees relying on the 4% rule. In a recent study, researchers from Morningstar, Texas Tech University and The American College analyzed drawdown strategies using a model designed to reflect today's expectations for future stock and bond returns. For a portfolio of 40% stock and 60% bonds, the 4% rule has just a 48% chance of success over a 30-year period, the researchers found. A retiree who wants a 90% chance that his money will last for 30 years would have to dial his withdrawal rate back to 2.8%. Or, if he wants the same dollar amount of spending that he would have received using the 4% rule, he will need to start retirement with 43% more savings. Advertisement To be sure, bond yields won't remain low forever. The study's model accounts for that fact, allowing yields to drift back to long-term averages over a period of years. But returns in the early years of portfolio drawdowns have a disproportionate impact on the portfolio's longevity, and that spells particular trouble for people just entering retirement. The findings "are a wake-up call" for retirees, says David Blanchett, head of retirement research at Morningstar Investment Management and co-author of the study. The study is just the latest in a series of recent arguments against the 4% rule—and even against the very concept of a "safe" withdrawal rate. Such rules of thumb are fundamentally flawed, some critics say, because they seek to match a relatively volatile stock-and-bond portfolio with a spending amount that remains constant, in inflation-adjusted terms, year after year. Under such rules, moreover, there's no link between the annual spending amount and retirees' actual expenses. And a portfolio's chances of surviving a fixed 30-year period aren't all that relevant, some argue, because what retirees really want is a portfolio that lasts a lifetime—no matter how long or short that may be. Here's a look at what works—and what doesn't—when it comes to stretching a nest egg over a long retirement. Build a Floor You can't predict your life span, your total retirement spending or your future investment returns. But you can predict with relative certainty your basic retirement expenses, such as utilities, food and clothing, as well as the amount of income you'll receive from guaranteed sources, such as Social Security, pensions and annuities. Match your essential retirement expenses with your guaranteed income sources, and you've gone a long way toward building a more secure drawdown strategy—without relying on any rules of thumb. Fred Webster, 57, is hoping to retire early and has calculated that his fixed expenses, such as utilities and property taxes, will be less than $1,000 a month. If he claims Social Security at 62, he'll get about $1,400 in monthly benefits, he says, or at least $2,400 monthly if he delays claiming until 70. Webster, an auto-parts manufacturing worker in Plymouth, Ind., can also tap a profit-sharing plan, a Roth IRA, a taxable brokerage account and rental income from his upstairs apartment to meet nonessential retirement expenses. "I compartmentalize my income," he says, adding that he's prepared to live without frills if his investments tank. Advertisement Online budgeting tools such as Mint.com can help you tally your spending and separate the essential from the nonessential expenses. Next, consider ways to maximize the rock-solid income sources that can help cover your essentials—starting with Social Security. While low bond yields have undermined the 4% rule, they reinforce the value of delaying Social Security for many retirees. For each year you delay claiming Social Security benefits beyond full retirement age, you get an inflation-adjusted benefit boost of 8%. Compare that to the inflation-adjusted yields currently available in the bond market—specifically, on Treasury inflation-protected securities. They're negative for maturities of ten years or less. "The government's offer is pretty good relative to current interest rates," says Jason Scott, managing director at retirement-advice firm Financial Engines' Retiree Research Center. Retirees who find that their Social Security, pensions and other guaranteed income sources won't cover basic expenses should consider immediate annuities to fill the gap, retirement experts say. Wade Pfau, professor of retirement income at The American College, a Bryn Mawr, Pa.–based institution for financial professionals, recently went in search of the optimal portfolio for retirees seeking to meet spending goals while preserving a given percentage of retirement assets at death. His research, which also factored in today's low-yield environment, found the best outcomes were produced by portfolios consisting of stocks and single-premium immediate annuities. Portfolios consisting of just stocks and bonds produced the worst outcomes. Consider a 65-year-old husband and wife who have claimed Social Security and need to draw an inflation-adjusted 4% annually from their retirement portfolio to meet spending needs. In the worst 10% of scenarios, Pfau finds, this couple could meet about 94% of lifetime spending needs and have nearly 60% of their initial retirement balance remaining at death if they use an asset allocation of 50% stocks and 50% single-premium immediate annuities. With a 50% stock and 50% bond portfolio, the couple would meet only about 88% of spending needs and have less than 40% of assets remaining at death. "It's likely bonds will be depleted" in these worst-case scenarios, Pfau says, "but the [annuity] continues to make the payment." Advertisement While current market conditions make some retirees wary of purchasing annuities, "I don't buy the argument that it's a bad time to buy annuities because interest rates are low," Pfau says. "It's a bad time to do anything because interest rates are low. And if you don't buy annuities, you have to draw down your portfolio more, waiting for interest rates to go up." Calculate your potential monthly income from an immediate annuity at www.immediateannuities.com. Get the Right Mix Confronted with all the bad news about the 4% rule, retirees may be tempted to aim for higher returns by increasing allocations to stocks and riskier, higher-yielding bonds. But that's likely to make retirement a bumpy ride—and it doesn't have much impact on the amount retirees can safely spend from their portfolios. Consider a retiree with a 20% stock portfolio who wants a 90% probability that his money will last 30 years. His safe withdrawal rate would be 2.7%, according to the study by Blanchett and his fellow researchers. If the retiree boosted his stock allocation to 60% and accepted an 80% probability that his money would last 30 years, his safe withdrawal rate would be only slightly higher, at 3.2%. Indeed, some advisers make the case that a properly managed retirement drawdown strategy can start with a quite conservative asset allocation. In Financial Engines' Income+, a managed-account service for 401(k) participants entering and in retirement, the recommended stock allocation at retirement is just 20%. About 65% of the portfolio goes into bond funds that provide a "floor" level of payouts for the retiree from age 65 to 85, with shorter-term bond funds supplying near-term payouts and longer-term bond funds providing the payouts further down the road. The target stock allocation gradually declines until age 85, with money moved from stocks to bonds used to secure additional payouts for the retiree. The remaining 15% is also invested in bond funds, but it is set aside so that the retiree has the option of purchasing an annuity to provide payouts from age 85 on. Advertisement No matter how you build your floor—whether from bond funds, immediate annuities, pensions, Social Security or all of the above—it should help ease anxiety about covering basic expenses in retirement. An emergency fund, perhaps several years' worth of living expenses held in cash and high-quality short-term bond funds, should also be set aside in case of sky-high medical bills, costly home repairs or other nasty surprises. You can then view riskier holdings, such as stocks, real estate and commodities, as the fun money to be tapped to cover nonessentials, such as travel. This approach gives retirees the courage to maintain riskier holdings through market ups and downs—a healthy way to invest, says Michael Finke, financial-planning professor at Texas Tech University. Stretch Your Portfolio, Painlessly Once you've built your spending floor, how can you make the most of your remaining investment portfolio? There are two relatively easy moves that are in effect guaranteed to boost returns and help your portfolio meet your spending goals: minimizing fees and making tax-efficient drawdown decisions. Investment-management fees take a bite directly out of returns and can seriously crimp your portfolio's spending power over the course of retirement. Consider a retiree with a 50% stock and 50% bond portfolio. If she invests in high-cost funds with annual fees of 1.25% of assets and uses an initial withdrawal rate of 3.3%, she'll have an 85% chance that her portfolio will last 30 years, according to projections from Vanguard. If the retiree instead uses low-cost funds with fees of 0.25%, she'll have the same 85% success rate using an initial withdrawal rate of 3.8%. If she retires with a $300,000 portfolio, investing in high-cost funds costs her $45,000 in spending power over 30 years. To keep even more money in your pocket, and not in Uncle Sam's, start retirement with money spread across taxable, tax-deferred and Roth accounts. The conventional wisdom says that retirees should first tap their required minimum distributions, then taxable accounts, then 401(k)s and other tax-deferred accounts, saving tax-free Roths for last. That way, tax-deferred and tax-free money has more time to grow. But retirees looking to minimize taxes will find some exceptions to this rule. In many cases, for example, it may make sense to tap IRAs in early retirement while waiting to claim Social Security benefits. Younger retirees can also make tax-efficient moves if they expect to be bumped into a higher tax bracket after starting required minimum distributions at age 70. For example, a 65-year-old retiree in the 15% bracket today may anticipate leaping to the 25% bracket when his RMDs begin. This retiree should consider taking enough money from his 401(k) or IRA—in either a standard distribution or a Roth conversion—to fully use the 15% bracket, which tops out at $72,500 for couples filing jointly this year, says William Reichenstein, principal at Social Security Solutions and professor at Baylor University. That way, he reduces the amount of 401(k) and IRA distributions he's required to take later, when he's in a higher tax bracket. Any additional spending money needed in early retirement can be drawn from a taxable account. (Kiplinger's has a partnership with Social Security Solutions; visit kiplinger.socialsecuritysolutions.com.) Another way to minimize taxes on 401(k) distributions: Save a chunk of money in these accounts to be withdrawn in years when you have high medical expenses, Reichenstein suggests. A retiree anticipating spending a couple of years in an assisted-living facility at a cost of $45,000 a year, for example, might reserve $90,000 in his 401(k). He'll get a significant tax deduction for the high medical expenses, putting him in a low tax bracket and making those years an advantageous time to take distributions from his 401(k). The most tax-efficient drawdown strategies can make a portfolio last about six years longer than the least tax-efficient strategies, Reichenstein concluded in a recent study. Tax-efficient drawdowns are "the easiest, most painless way to get back a little of that decreased return" resulting from low yields, he says. Although some retirement experts maintain that the 4% rule is still a reasonable starting point for drawdown strategies, they stress the importance of staying flexible. "There's this rigidity around the 4% rule of thumb," says Maria Bruno, senior investment analyst at Vanguard. In reality, she says, advisers and investors who follow the rule watch market movements and "adjust accordingly." Rik Reed, a 51-year-old software developer in Pilot Point, Tex., is building plenty of flexibility into his retirement drawdown strategy. He hopes to stop working in five or six years, and he's planning to use the 4% rule as a rough guideline. But he won't retire until he knows he can live on just a 2% withdrawal rate. "I want to have enough fluff in my portfolio" to withstand market downturns, he says. He plans to have about four years' worth of living expenses set aside in certificates of deposit or other rock-solid holdings by the time he retires, and he's prepared to live on about $25,000 a year, which "wouldn't be a lot of fun, but it would cover the necessities," he says.