By John Spoto

Retirees face the challenge of converting a nest egg accumulated over a lifetime of work into income that will last for as long as they live, a period that can last three decades or longer.

One of the most important issues they must address is how and how much to withdraw from their investments each year. The decision involves a trade-off between spending too much and running out of money and being unnecessarily frugal and depriving themselves of a lifestyle they could otherwise afford.

The amount that can reasonably be withdrawn from a portfolio each year depends upon several factors that differ for each person, including assumptions about investment returns, inflation, the length of retirement, and the approach used to drawdown the funds. There are two common draw-down methods each with advantages and disadvantages. By understanding both of them, retirees can craft a "hybrid" of the two that best fits their specific situations. Let's take a look at them.

The first involves withdrawing a pre-determined percentage of the portfolio for the first year and then adjusting that dollar amount for inflation each subsequent year. For example, a retiree with $500,000 in retirement savings decides to withdraw $15,000, or 3 percent, of the portfolio for the first year. If during that year inflation is 2 percent (i.e. 2 percent of $15,000 is $300), the investor would increase the withdrawal amount to $15,300 for year two. These inflation adjustments would continue each year, so the retiree could enjoy the same predictable purchasing power throughout retirement.

However, because withdrawals are increased every year by the amount of inflation regardless of the portfolio's performance, a prolonged downturn in the financial markets (and therefore the portfolio) could substantially deplete assets. During these periods, those who use this approach must be prepared to make "as-needed" adjustments to spending to avoid prematurely exhausting the portfolio.

Simulations run by academic and financial institutions, using historical investment returns and inflation rates, indicate a balanced portfolio has a good chance of lasting 30 years using an initial withdrawal rate of between 3 percent and 4 percent. Like most generalizations, however, they do not apply to everyone. Each retiree needs to evaluate his or her own personal circumstances and then adjust those percentages and dollar amounts accordingly.

The second method involves withdrawing a pre-determined percentage of the portfolio's beginning balance each year. In other words, the amount withdrawn is directly tied to the performance of the investments during the prior year. Spending is reduced during and after poor performance and increased when investments recover.

As an example, let's say a retiree with $500,000 in retirement savings decides to withdraw $20,000 or 4 percent of the portfolio in the first year of retirement. If the markets do well and by year-end the portfolio swells to $600,000, the drawdown amount for the following year would be 4 percent of $600,000 or $24,000. If during the next year, the portfolio experiences a steep decline and the year-end value is $450,000, the withdrawal would be reduced to 4 percent of $450,000 or $18,000.

Because poor investment returns are partially offset by a reduction in withdrawals, this strategy minimizes the chance the retiree will consume the portfolio too quickly. On the other hand, because the dollar amount of the draw-down fluctuates with the portfolio's balance, retirees should be prepared to reduce spending when warranted. The reality, however, is that many may be unable to tolerate these spending adjustments.

Deciding how much to spend and how to spend from your savings is an important issue that most retirees will confront. The best solution may be a "hybrid" of the two approaches we examined.

Regardless of the withdrawal strategy employed, being flexible, and making sensible adjustments to spending when conditions dictate will increase the chances of realizing a secure retirement.

John Spoto is founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.