If you've ever looked what kind of nest-egg you are going to need to retire, you've undoubtedly come across the standard rule of thumb only allows withdrawing 4% a year if you want to have your savings last at least 30 years.



So if you wanted to start withdrawing $80k a year, you would need to have $2 million dollars in savings. Now that is a mighty sum, and many may consider it out of reach, especially if you are starting late in the game.

But, why only 4%? If the stock market averages 11% a year, why shouldn't your nest-egg last forever if you were taking out anything less than 11%. Let's take a quick look at the original study that forms the basis of this recommendation to understand its underlying assumptions. With that information we will see if we can shape our investment strategies to give us more from our savings.

The original work that many of these projections are based on was a paper by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz. As you read through this work, you'll find a few basic assumptions:

1) The goal of the analysis is to maximize the likelihood that your nest-egg will last for the desired period of time (in the study it is varied from 15 to 30 years). This is quite different from maximizing the most likely size of the portfolio.

2) The analysis is done by running a simulation using the historical data from 1926 to simulate the probable rates of return on your portfolio.

3) It also assumes the CPI (Consumer Price Index) predicts the inflation rate that you would need to match in your withdrawals (e.g. if you took $10k out the first year, and the CPI in the simulation went up 5%, in the 2nd year you would withdraw $10.5K)

4) The rate of withdrawal is never modified based on the portfolio performance. (Basically you would never reduce your spending as a function of your remaining funds.)

5) No tax or transaction costs were taken into account.

The working assumption was that the portfolio would need to last 30 years. This matches the most common retirement scenario (retire at 65, median life expectancy would be around 20 years, but a 50% chance of greater than 20 years life expectancy).

Finally, the only investment options were those with historical returns tabulated in the Ibbotson report, basically the S&P 500 as the stock market, and a family of differing maturity bonds for a bond portfolio.

With those constraints, then it turns out that you would not pursue a strategy of maximum returns on your portfolio (which is the case with a portfolio of 100% stocks), but more one that gives the best risk/ reward performance. The portfolio that gave the highest probability of lasting 30 years was found to be a 75%/25% mix of stocks and bonds, even though a 100% stock portfolio yielded about 1% more a year, the risk (as measured by the standard deviation of the annual returns) was reduced by about 20% with the diversified portfolio. For a 4% withdrawal rate, there was a 98% probability that it would last 30 years.

So, what are the factors that would allow us to increase the amount we could withdraw each year (or in effect reduce the amount we need to save)?

1) Reduce the number of years you want to ensure income. The only practical way to do this is to retire later. Helpful, but not the solution most of us want to count on. Also, to give some idea of how effective this is, if the target lifetime of your nest-egg is reduced from 30 to 25 years, the withdrawal rate can't even be increased from 4% to 5% and still keep a greater than 90% probability that it will last the target lifetime. You have to reduce the target time period to 20 years just to increase the withdrawal rate from 4% to 5%.

2) Accept a lower inflation rate. If you think your costs will be fixed, or expect that your rate of spending as you hit the 80's and 90's will go down, it may be appropriate to target a higher rate of withdrawal. Of course this has it's own set of risks, but the reality is that most 95 year olds are not traveling, eating out as much, keeping a vacation home, etc. as most 65 year olds. The flip side of that is the medical and extended care costs, which aren't captured by the CPI anyhow.

If you assumed no inflation at all in the analysis above, you could increase your withdrawal rate to 6% and still have a 98% chance the portfolio would last 30 years. That may not seem like much, but it's a 50% increase in income.

3) Increase the returns on your investments. This is the holy grail that most folks look for when evaluating their investment performance. While that can be helpful, keep in mind that the best result above was achieved with a lower yielding, lower risk portfolio than the 100% stock portfolio.

4) Reduce the risk of your portfolio. This is actually the key to success, especially when coupled with an increased return. To give some idea of the leverage of risk, if you can cut the risk (in this case the standard deviation or the amount of variation of the annual returns) in half without increasing the yield at all, you could increase the amount withdrawn each year by more than 50%.

Few investors understand the impact of improving the risk reward ratio of their portfolio. Not only will that help stay the course on following our investment plans, but in the long run it can actually reduce the target amount needed to sustain the a retirment income stream.