What's the number? That question applies to the amount of money a retiree has to accumulate to achieve and maintain their personal lifestyle in retirement. Working backward from a projected budget of living expenses gets us to an annual income requirement. Subtracting Social Security benefits and any other income sources, such as pension income, leaves us with what we need to extract from a retirement account to make up the difference.

The magic number you see in most literature on the subject is 4 percent. This means that you can safely extract 4 percent from a retirement nest egg and not run out of money. If 4 percent is the safe number, then you need $100,000 of capital for every $4,000 of annual income.

In truth, the process may not be as foreboding as the financial services industry leads us to believe. The American Association of Individual Investors (which everyone should join) periodically runs "retirement income extraction rate" articles in their monthly magazine. The July 2012 issue used a 50/50 stock bond simulation that covered a period from 1926 until 2005. Checking rolling time periods of 30 years each during that swath of almost 70 years, and assuming a 4 percent extraction rate, only 5 percent of the 30-year periods would have resulted in a total draining of the account. But who wants to live with even a 5 percent chance of running out of money?


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For openers, the studies use just raw investment metrics such as the S&P 500 index and a total bond index fund. In both cases, we can do better when our objective is to generate income from investments so we can leave the capital itself alone. Next, retirees should view themselves as long-term, buy-and-hold investors. They are not saving with the need to someday cash in to pay for a college education or a vacation home.

Starting with the bond side of a 50/50 mix, we can afford to live with some additional risk here because our main objective is to generate income. High-yield corporate bond funds can play a useful role. Their income yield today is between 5 and 6 percent, but their capital value will fluctuate. Over time, it will actually drop slightly as bond managers sometimes accept a loss to dump a bond before it goes into default. Vanguard's fund (closed for the moment) is a good example, Over the years, it has lost an average of about 1 percent per year in capital value, but the yield in most of those years has been 7-8 percent -- which more than compensates.

Emerging markets bond funds, like one managed by T. Rowe Price, also offer higher yields in the 6-7 percent range with some short—term risk to capital values, but bonds in foreign countries, like any others that don't default, snap back to their original value sooner or later when they reach maturity. Mutual funds that invest in these bonds typically hold them during bond market downdrafts and wait for them to mature so they can be rolled over into new bond issues. All this can be going on while the fund holder enjoys regular monthly interest payments automatically deposited into their checking accounts.

As for stocks, the focus is on stocks that pay dividends. So-called "Equity Income" value funds and funds like Vanguard High Dividend Yield Index create a quarterly dividend income stream that flows into checking accounts to pay bills. The capital itself can remain untouched. Over the past 40 years, through the stock market's eight major crashes, we could have ignored each plunge and just waited for the snapback. In the meantime, our 50 percent stock portion has increased to help the entire nest egg keep pace with inflation.

Rebalancing the 50/50 split further increases the stability of the account. If we don't rebalance, then the stock portion over time can easily find its way to becoming 70 percent or more of our account. With too much money in stocks, we could be tempted to bail out entirely in the next major crash. Maintaining the 50/50 split helps to ward off a panic-stricken exit from stocks and the disaster that results. Living with bonds that involve more risk and selecting stock funds that pay dividends can generate more income and reduce the need to chew into capital. Also, be careful how much you pay for advice and for on-going mutual fund annual expense ratios. If you can save a full 1 percent in a combination of both cost components, you just increased your annual extraction rate by 25 percent. -- to 5 percent per year.

So the specter of running out of money goes away when we build in a more retirement-specific investment mix rather than just the broad indexes used in academic studies. At the same time, periodic rebalancing and keeping costs low can constitute the glue that holds it all together. Combining all four improvements might bring a 5 or 6 percent extraction rate within the realm of possibility.

Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505 or sbutler@pensiondynamics.com.