Everything I read on the subject tells me that the most anyone can safely expect to take as income from their retirement accounts is 4 percent per year. Kiplinger's Retirement Report has a cover article this month titled "Make Your Savings Last a Lifetime."
In the article, experts from several of the major financial institutions weigh in on their various strategies for extracting income and they all arrive at that magic 4 percent. The industry secret that they all fail to point out is that the real number is 5 percent -- 25 percent more income -- except that the financial industry's business model calls for THEM to be paid that 1 percent.
Sure enough, as we begin to hear different "drawdown" strategies from a variety of industry retirement advisers from companies like J.P. Morgan and T. Rowe Price, the strategies involve such machinations as starting with 4 percent of your retirement nest egg and raising it every year (in dollars) based on the inflation rate. If the dollar amount in the year of a market crash suddenly amounts to, say, 6 percent of the nest egg amount that year, consider doing some course-correcting.
Another approach would be to forget trying to adjust for inflation and consider, instead, an approach that starts each year with the extraction rate of 4 percent of assets, but that includes both a floor and a ceiling on changes in the dollar amount. A $1 million account producing $40,000 per year, or 4 percent, might rise by the end of a good year by as much as 10 percent. On the now $1,100,000, what could now be $44,000 of annual income, the above strategy would cap the income increase at just 5 percent more, which would mean taking only $42,000 -- leaving the other $2,000 to be added to the nest egg.
Conversely, if the asset value dropped by 10 percent to $900,000, the income normally dropping to $36,000 would only drop to $38,900 -- a reduction amount that ignores the actual 10 percent drop in asset values. The idea is that saving some of what could have been paid out during the good years will make up for the more generous payouts during the bad years.
While the many different strategies involve variations of a central theme, all are paddling upstream to mystify the process and create a reason for their existence -- and the proponent's annual fee. Most of the different models make the unsettling assumption of a 10 percent probability that the retiree will run out of money in 35 years. I don't know about you, but I would hate to see my assets start going down the drain when I reached my late 80s even if the odds were just 10 percent.
A simple way to avoid ever running out of money is to set up a 50-50 mix of stocks and bonds. Start by spending only the interest from the bonds and only the dividends on the stocks. Select bonds that are just below investment grade so that the interest is a little higher -- almost 5 percent currently. Select stocks that pay relatively high dividend yields -- about 3 percent currently like the so-called "Dogs of the Dow," utilities funds or funds that focus on high-dividend-paying stocks.
With this mix of carefully selected income-producing investments, the bond half of the portfolio will be contributing 5 percent and the stock half will be contributing 3 percent.
The average income from both halves combined will be 4 percent. From the stock side, then, we can safely extract 2 percent of the nest egg per year, which will more than be offset by average annual gains from stocks. This 2 percent from the stocks works out to 1 percent for the entire portfolio, and "voila." We are living safely on a 5 percent total extraction rate.
The remainder of the capital left in equities should rise to keep pace with inflation. You can ignore the periodic downdrafts in capital value because you are the ultimate long-term investor, and beyond the 2 percent extracted from stocks (just 1 percent of the total account) you are barely touching the capital. The same approach applies to the bonds, which will also fluctuate in capital value -- fluctuations you can ignore because you're only spending the interest they generate.
To implement this strategy, use only dirt-cheap mutual funds that provide the necessary high interest and dividend yields at an annual expense ratio of less than 0.3 percent. Unfortunately, there's no room here for the 1 percent adviser or financial institution unless you want to pay them 20 percent of what could otherwise have been your income.