How to Withdraw Your Pension Money -- and Not Go Broke

When you retire, the last thing you want is to run out of money. But with a little planning, you should be able to withdraw a comfortable wad of cash to live on each year.

A majority of retirees choose to receive their retirement benefits in one lump sum, typically rolling over their investments into IRAs. There are a couple of advantages to this. First, taking a lump sum allows more investment options, because you're no longer limited to offerings in your 401(k).

Second, if you want to leave money to beneficiaries, IRAs give you more flexibility than 401(k)s. Unlike a 401(k), an IRA has a "stretch-out" feature that allows your heirs to make minimal withdrawals from an inherited retirement account.

Tax-wise, it doesn't matter much whether you leave your money in a 401(k) or roll it into an IRA. Both options allow the money to grow tax-deferred. And in both cases you'll pay ordinary income tax on what you withdraw.

But be aware of a possible downside to taking a lump sum: It's the most complicated way to take benefits. (As we noted in a previous story, folks lacking in investment savvy may be better off receiving benefits through an annuity, which would ensure them a regular income.) With a lump sum, you'll need to do some rigorous financial planning to make sure the money lasts until you die.

Investing Your Lump Sum

A sound retirement portfolio yields a predictable income stream, while allowing your capital to grow enough to keep you in comfort throughout your retirement.

The most sensible way to accomplish this is to invest a portion of your retirement account in stocks, while using the rest to construct a laddered bond portfolio that will provide you with income to live on.

A laddered bond portfolio consists of bonds with varying maturities, from short term to long term. When a portion of your bonds comes due, you use the principal to buy more bonds of the same maturity, so you'll always maintain a diversified portfolio of varying maturities.

Why do you need both short- and long-term bonds? Longer-term bonds offer higher yields, but they're also much more volatile. If interest rates or inflation rise, the price of long-term bonds will nose-dive. To offset that, you need short-term bonds, which are less volatile but offer lower yields. "That way, you're not locking your entire portfolio into either long- or short-term maturity," says Philip Cook, a certified financial planner in Torrance, Calif. "But, buying a portion of long-term bonds, you will get a higher rate overall than if you simply put all your money in short-term bonds."

Under current conditions, Cook says he wouldn't recommend buying bonds with maturities longer than 10 years, since they don't offer enough extra yield for the additional risk. Also, you'd want to combine government securities with some combination of corporate bonds, which offer extra return.

Combining a laddered bond portfolio with equities gives you a reliable income stream to cover your expenses (the bond part) and the potential for significant growth (the stock part), offering a long-term hedge against inflation.

How much you invest in stocks vs. bonds depends on your age, risk tolerance, income from other sources, and desire to leave a bequest. Hard and fast rules don't apply. For example, you might expect an elderly investor to overweight his portfolio in bonds, which offer greater security. But maybe he's also receiving income from a defined-benefit pension plan and wants to leave money to heirs. In that case, he may prefer to tilt his portfolio toward stocks.

Making Withdrawals

Now for the sweet part: withdrawing cash to pay for your sailing lessons and leisurely jaunts to wine country.

Unfortunately, investors often overestimate how much they can safely withdraw. A survey by the Employee Benefits Research Institute (EBRI) found many investors think they can withdraw as much as 10% or 12% each year.

But in fact, a withdrawal rate of just 4% is considered reasonable by most financial planners. "The 4% figure usually refers to the percentage of the portfolio, pretax, that a person can withdraw and have a 90-plus percent degree of confidence that the money will last, adjusted for inflation, for, say, a 30-year retirement period," says Dan Moisand, a certified financial planner and president of Optimum Financial Group in Melbourne, Fla.

However, the 4% withdrawal rate only works if you've constructed a portfolio with a reasonable balance between stocks and bonds. Dump too much cash in either asset class and you may run out of money too soon. For example, if you invest 80% of your retirement account in bonds, you'll have a stable portfolio, but your money probably won't grow enough to sustain you over the decades, especially if inflation picks up.

Likewise, if you allocate 80% to equities, you open yourself up to volatility at a time you can ill afford it. "If you've got a down market in the first two or three years of your retirement, i.e. 1973-74, especially if you're pulling money out, you're going to self destruct," says George H. Coughlin II, a certified financial planner in Walnut Creek, Calif., and founder of Iraplanning.com, which provides information on IRA distributions and retirement plans.

Indeed, one of the most dangerous misconceptions among retirees is the expectation that they'll reap returns equivalent to the historical average of the stock market. According to Ibbotson, stocks gained an average of 10.7% annually between 1926 and 2001. But remember, that average holds true over time. As an investor, it's also possible that you could be unlucky and encounter market declines at the beginning of your retirement.

The best way to protect yourself, then, is to diversify your portfolio -- which you should have been doing all along as you approached retirement. With that in mind, it's worth it to start preparing now.