Savings that last as long as you do

By Jonathan Clements, The Wall Street Journal

UNDATED -- Folks joke about leaving behind nothing but a check for the undertaker -- and the check, of course, bounces.

Don't want to cut it so close? Unfortunately, if you follow one of the most commonly advocated retirement-spending strategies, there's a real risk that you will outlive your money.

With this strategy, you build a balanced portfolio of typically 60 percent stocks and 40 percent bonds and settle on a withdrawal rate, often set at 5 percent. That is the percentage of your portfolio that you withdraw in the first year of retirement. Each year thereafter, you step up the dollar amount withdrawn along with inflation.

For instance, if you adopted a 5 percent withdrawal rate, retired with $400,000 and inflation ran at 3 percent, you would pull out $20,000 in the first year of retirement, $20,600 in the second year, $21,218 in year three and so on. These amounts include any dividends and interest kicked off by the portfolio.

Not surprisingly, retirees like the idea of getting the same inflation-adjusted income every year. But there's a hitch: If you slavishly follow the strategy, you could rapidly deplete your nest egg if markets are unkind. Indeed, Baltimore's T. Rowe Price Associates calculates that, with a balanced portfolio and a 5 percent withdrawal rate, there is a 42 percent chance you would run out of money over a 30-year retirement.

What's the alternative? Here are three strategies that, while they also have their drawbacks, do at least eliminate the risk of outliving your portfolio:

Playing the Percentages: As with the strategy described above, you might withdraw 5 percent of your portfolio's value in the first year of retirement. But in subsequent years, you don't increase the dollar amount along with inflation.

Instead, you continue to withdraw 5 percent of your beginning-of-year balance. If your portfolio performed well the year before, you would get to spend more. But if your holdings took it on the chin, you would be forced to cut back.

"In general, it's a safer method than withdrawing a fixed dollar amount, because you're automatically withdrawing less when your assets are reduced by a bear market," says William Bernstein, an investment adviser in North Bend, Ore. "If you take a fixed percentage, you will never, ever run out of money. But you can still go wrong."

In particular, you could find your annual income dwindling if you either mismanage your portfolio or you use too high a percentage. After all, to generate a stream of income that grows along with inflation, your portfolio's return has to be higher than the percentage you are withdrawing. Still, if you can adjust to the annual changes in income, the fixed-percentage strategy strikes me as a good option.

Income for Life: Over the past few years, I have become a fan of immediate-fixed annuities. These policies can come with all kinds of bells and whistles. But in its simplest form, an immediate annuity involves handing over a chunk of money to an insurance company, in return for which you get a check every month for the rest of your life. In essence, it is a way of creating your own company pension.

"Immediate annuities are really good if you have no interest in finance," says Henry Hebeler, author of "J.K. Lasser's Your Winning Retirement Plan." "But the big problem is inflation," which will gradually erode the value of an annuity's fixed payments.

Because of inflation and because of the risk that you don't live long enough to get much benefit from an annuity, you might put just 25 percent or 30 percent of your retirement nest egg in one of these products and then invest the rest in a mix of stocks and bonds.

Clipping Your Coupons: An old financial rule of thumb says you can spend your dividends and interest income, but you should never touch your capital.

"This is what most people have done in the past and it's still used by the vast majority of retirees, even those who are unable to articulate their spending discipline," Mr. Hebeler says.

But is it a good strategy? If you are heavily invested in stocks, you may find that your portfolio generates scant spending money. "Stock dividends have generally gone down as a percent of stock price over the years, as companies have put more emphasis on growth," Mr. Hebeler notes. "That leaves less cash for the stockholder."

You could, of course, compensate by putting more in bonds. But that may leave you vulnerable to inflation. If your interest income doesn't grow and inflation runs at a modest 3 percent a year, the spending power of your interest income will be cut in half after 23 years.

There's another drawback: By refusing to dip into principal, you may force yourself to scrimp unnecessarily. Still, while it wouldn't be my first choice, the "never spend capital" strategy can work well.

With the right mix of stocks and bonds, you should generate a decent stream of income, enjoy some inflation protection and be confident you won't outlive your money. And the local undertakers will be happy. After all, they are likely to get paid.

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