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The 4% Retirement Rule and When to Break It

The 4% rule is supposed to show how much to withdraw from savings when you retire, but here's why it's flawed.

One of the most important decisions at retirement is how much to withdraw from savings each year. And because portfolios took a major hit over the past few weeks, this decision is more important than ever.

Setting a withdrawal rate is a delicate balance. Withdraw too much, and you risk outliving your money. But withdraw too little, and you may sacrifice the lifestyle you worked so hard to attain.

Maybe you've heard about the 4% rule, which says if you withdraw 4% of your portfolio in your first year of retirement and adjust for inflation every year, you have a 90% chance of your money lasting for 30 years.

This rule has been tested against thousands of possible outcomes using historical data. So it's no surprise that it works out mathematically. Let's say you retire this year with a $1 million nest egg. You withdraw 4%, or $40,000, the first year, then increase that amount each year by the historical average inflation rate of 3.5%. You'd pull out $41,400 in year two, $42,850 in year three, and on up to nearly $77,000 in year 20 and $108,475 in year 30. With just a 6% annual return on your investments and 3.5% annual inflation, you'd be left with almost $800,000 in 2037, or the inflation-adjusted equivalent of about $272,000.

Problem is, the real world is a bit more complicated: Most significant, return figures fluctuate from year to year. Even if your annual returns average out to 6%, your real-world portfolio would look considerably different if in your first year of retirement you experienced a 10% loss -- or a 15% gain.

So while the 4% rule can be useful as a planning tool, it's too rigid to adopt as your personal withdrawal scenario. As it turns out, the man who in 1994 introduced the 4% rule, the El Cajon, California-based planner Bill Bengen, doesn't recommend it anymore. "The figure is stuck in the corner of people's minds, and I don't know how to get it out," he told BusinessWeek recently.

This year highlights the trouble with Bengen's rule: Even after the Dow Jones Industrial Average posted its biggest point gain ever on Oct. 13, the S&P 500 remained down nearly 32% for 2008, pulling the average diversified fund down more than 20% in the past 12 months.

Consider the aforementioned $1 million nest egg, with its $40,000 first-year withdrawal under the 4% rule. If that $1 million has shrunk to $800,000 this year, the picture changes quite a bit. The first-year withdrawal falls to $32,000, and remains about 20% lower, year after year.

As a result, it's important to develop a withdrawal strategy flexible enough to adapt to varying conditions in the market and in your personal life. Bengen suggests building a withdrawal rate by what he calls the "layer cake" method, with variations depending on the retiree's risk tolerance, the market's performance and lifestyle expectations.

For example, he offers clients the choice of higher withdrawals early in retirement, if they accept the premise that they'll spend less as they age by cutting back on discretionary spending such as travel or hobbies. They might also base withdrawals on market performance, withdrawing as much as 25% more than planned after good years and significantly less after bad.

Aggressive investors -- those planning on a 20-year retirement, with a portfolio of 40% large-cap stocks, 20% small-caps and 40% bonds and willing to accept an 80% level of confidence that their money will last -- can withdraw 7.6% of assets early on. As years go by, they can reduce annual withdrawals to 4.9%. (For more information on Bengen's latest research, check out his Web site.

The right withdrawal rate for you depends on a number of factors, such as the size of your nest egg, life expectancy, health and insurance status, investments and spending habits. What's more, your withdrawal rate may change over the years to account for the unexpected changes to your life or portfolio, either positive or negative.

There is no one answer -- or even one rule of thumb -- that works for everyone, aside from this: Planning ahead carefully will help you avoid outliving your savings and allow you to enjoy your golden years as much as possible.