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By Jason Stipp and Christine Benz | 09-26-2012 02:00 PM

Clearing Up Confusion on the 4% Rule

Plus, Christine Benz answers a reader question about tamping volatility when using a total return approach in retirement, and suggests a couple of very long-term retirement fund picks.

Jason Stipp: I'm Jason Stipp for Morningstar.

We recently held a couple of live Q&As (click  here and here) with Morningstar readers, and we answered lots and lots of your questions, but we weren't able to get to them all.

So, today, we're playing catch-up and answering some retirement-related questions with one of our panelists, Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: No shortage of retirement-related questions. We were able to answer a lot of those at our recent events. But we have a few that we didn't get too, specifically, that we're going to cover it today.

The first one is about withdrawal strategies--obviously very important to folks who are in retirement mode and taking money out of their portfolios, and it has to do with a very well-known rule of thumb, the 4% rule. The question is can you explain the 4% withdrawal recommendation for a retirement account?

Benz: When you hear that 4% rule, I think a lot of people get confused about what it means. But what the classic 4% rule means is that you take 4% of your portfolio balance on day one of your retirement, and that's the amount that you can withdraw in year one of your retirement. Then you can inflation-adjust that amount--so nudge it a little higher to keep up with cost of living increases--on an annual basis.

And under the research that has been done--and there has been a lot of research done on this particular topic--the ideas that that portfolio could last roughly 30 years through a variety of market conditions, and it would be a roughly 60% equity, 40% fixed-income portfolio. [Research suggests] that person employing that strategy would have a very good chance of not outliving his or her money during his or her lifetime.

Stipp: So, under that methodology, then, you get one amount on year one, and that amount then is adjusted by inflation each year.

So, 4% doesn't mean each year I take 4% of my portfolio value, and that's what I have that year?

Benz: It doesn't, although that is another strategy.

In fact, in conversing with some of our Morningstar.com readers, that's the strategy that they use, and that's the strategy they like, because it does plug their portfolio into market sensitivity--what's going on in the market. And that has been one frequent criticism of the 4% rule. So, even though it gives you that fixed, inflation-adjusted dollar amount, you're really not responding to big periods of market down-draughts, when you may want to actually be taking less, nor are you responding if your portfolio does particularly well. So, you're not giving yourself a raise if you've had really great results. So, by taking a fixed percentage per year, you're more plugged into the market environment.

On the downside, it means that your actual paydays will change a lot, and that's not something that some people want during retirement. They want more or less a static stream of income.

So, it does come down to individual preference and the extent to which individuals are willing to adjust their lifestyles to accommodate what's going on with their portfolios.

Stipp: Some interesting facts about 4% rule--thanks for helping to clear some of those up, Christine.

A second question also has to do with building income from a portfolio and getting income out of a portfolio. A reader asked, "How can a retiree reconcile a portfolio designed for total return with the need for downside volatility protection?"

So, before we answer that specific question, let's talk about total return, investing for total return, versus income investing. A lot of folks are very focused on [income investing] right now--getting an a income stream from investments without touching principal. What are the pros and cons of those two methods of investing in retirement?

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