Third in a series of three articles on retirement planning and saving.

You long ago understood the importance of saving for retirement, you made saving a priority and you are now ready to retire. You even understand that balancing your spending with your available resources is critical to enjoying what will hopefully be many years in retirement. But how to go about determining the proper “withdrawal rate” which will allow your savings to last your lifetime?

(Retirement should be broadly defined as not needing to earn a wage to support yourself and those who depend on you. Continuing to work in retirement, whether for pay or as a volunteer, has huge benefits. First, any earnings will help extend retirement savings. Second, there are significant intangible benefits such as social and intellectual stimulation. Finally, if you’re working, you’re probably not spending.)

Traditional planning models used a range of 60% to 80% of final salary as the retirement need and many retirees find themselves at the high end of that range. There are also three “phases” of retirement, each with its own financial demands – the transition during which lifestyle adjustments are made and large one-time expenses may be incurred, the core period during which the new retirement lifestyle is fully enjoyed and the period of decline at the end of life.

Since spending can be adjusted to some extent, it is critical to know what level of withdrawal a portfolio can support. For the time being, Social Security will continue to serve as the first layer of income, and the annual benefits statement from the Social Security Administration is an invaluable part of planning. The next layer is company pension plans or any other financial arrangement which provides regular income; this includes income annuities but their potentially high costs and lack of financial flexibility means they should be used as part of a coordinated overall plan.

The seminal research on retirement withdrawals was done by William Bengen and published in a 1994 article in the Journal of Financial Planning. Bengen’s analysis was based on the historical investment performance of a portfolio with 60% stocks and 40% bonds and concluded that withdrawing 4% of the initial portfolio value each year would eliminate the risk of outliving the nest egg. Increasing that initial withdrawal amount annually for inflation still leaves a reasonable expectation of not running out of money for 30 years. (For example, a 4% initial withdrawal from a $1 million portfolio would be $40,000. If inflation is 3% the next year’s withdrawal would be increased by 3%, for a total of $41,200.)

This 4% rate is a departure from the more conservative approach of spending only the income from a portfolio, never principal. As is often the case, being more conservative can have its own risks. In today’s low interest rate environment, the income would likely be considerably less than in prior years. Maintaining a balanced portfolio relies on the potential for the stock portion continuing to grow over time and thus support greater total withdrawals over the course of retirement.

The “4% rule” has come under some criticism in the aftermath of the financial crisis and the “lost decade” during which the S&P 500 actually showed a negative return. A few years of poor performance immediately before or after retirement, for instance, could reduce the number of years a portfolio could support 4% withdrawals. More fundamentally, most experts are projecting lower investment returns in the foreseeable future as compared to long-term average returns.

It is certainly true that inflation and investment returns are impossible to predict. But as long as the fixed income portion of the portfolio earns income at the rate of inflation and the stock portion grows at 2% greater than the rate of inflation, both of which are reasonable, the 4% rule works.

The first step in beginning to draw from your retirement portfolio is to determine the proper asset allocation based on your overall objectives and tolerance for risk. There are a number of ways to accommodate withdrawals, but in each case the portfolio should be rebalanced annually to the target allocation. One approach is to have all the stock dividends and fixed income interest payments roll into a money market for distribution, with any remaining need taken from the fixed income investments. Another is to maintain two years’ worth of distributions in the money market, funded proportionally from stocks and fixed income and replenished annually during rebalancing. A third approach is to structure part of the fixed income so that there will be maturities each year for, say, the next five years that match your annual need, using those maturing investments to make withdrawals.

Of course, unforeseen things happen, and costly health issues are usually the major threat to retirement income and savings. Possible adjustments include reducing other spending and downsizing housing costs, and while these adjustments may not be ideal they will be more manageable if prior withdrawals have been properly controlled.

Transitioning to retirement can be both an opportunity and a challenge, and whether your retirement savings will last your lifetime could cause some anxiety. Having an understanding of reasonable withdrawals and an overall plan for retirement can help ease that fear and make retirement more enjoyable.