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New math on retirees' annual withdrawals

How much money can you safely withdraw from

How much money can you safely withdraw from your nest egg each year of your retirement? Credit: iStock

How much money can you safely withdraw from your nest egg each year of your retirement?

This most vexing question depends on the answer to some tough questions:

How long will you live?

What is the expected return of your assets?

Will your spending change during retirement?

To help retirees, many of whom were no longer eligible for standard pension plans, the academic community jumped in. The first study on the subject occurred in the 1990s. William Bengen published the earliest research in the October 1994 Journal of Financial Planning, "Determining Withdrawal Rates Using Historical Data."

Bergen tried to determine what the highest withdrawal amount of money, as a percentage of retirement assets, would be over the course of 30 years. He also factored in inflation, so after the base line percentage was determined, retirees could receive a bit more in subsequent years. Assuming that retirement portfolios had a 50/50 allocation for stocks and bonds, Bengen found that 4.15 percent was the magic withdrawal rate.

Soon after, in 1998, the "Trinity Study" tweaked Bengen's model by using a different bond index. The Trinity Study used long-term high-grade corporate bond returns instead of Bengen's 5-year intermediate-term government bond returns, which resulted in a slightly lower 4 percent withdrawal rate. Most advisers seemed satisfied with the round number of 4 percent, which meant they could tell clients that a portfolio of $1 million would support a first year withdrawal of $40,000.

There was almost universal agreement that 4 percent was the right number, all the way through 2007. But the financial crisis and recession blew up notions of the 4 percent rule, as investors faced plunging portfolios and a murky future. Academics soon worried that conditions under which the 4 percent rule was adopted no longer existed. After all, in the 1990s, when 4 percent became the de facto rule of thumb, investment returns were higher. At that time, balanced portfolios were earning about 8 percent annually. In the post-crisis era, those returns have been halved, which could spell trouble for retirees.

Earlier this year, a Morningstar report found that in order to safely assume (with 90 percent probability) that you would not deplete your retirement nest egg over a 30-year time horizon, you would need to reduce the safe withdrawal rate. Instead of 4 percent, it should be 2.8 percent.

That finding threw retirees and near-retirees into a tizzy, because a lower withdrawal rate meant that everyone would need a much larger nest egg. In fact, the seemingly innocent 1.2 percent drop in withdrawal rate "would require 42.9 percent more savings if the retiree wanted to pull the same dollar value out of the portfolio annually as he or she would get with a 4 percent withdrawal rate from a smaller portfolio," the report states.

Ouch!

For those frustrated by the notion of having to save all of that extra money, Vanguard Group has developed a hybrid strategy for spending retirement savings. Under the Vanguard method, you adjust your withdrawal rate from year to year based on creating a floor of 2.5 percent and a ceiling of 5 percent. Under the Vanguard method, you would withdraw less money in a bad year and be able to spend a bit more in a good year, which the company says would improve the likelihood of meeting long-term financial goals.

Of course, all of this is moot if you screw up other parts of the equation. As esteemed investment adviser Alan Roth has pointed out, how much you can safely spend each year from your nest egg "depends more on you than it does on market returns." He maintains that controlling your investment expenses and emotions is far more important than portfolio performance.

After all, if you keep buying high and selling low and lard up your portfolio with expensive, commission-based funds, you can throw out all of the safe withdrawal rules.

Jill Schlesinger, a certified financial planner, is a CBS News business analyst. She welcomes emailed comments and questions.

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