Can Your Portfolio Supply You With the Retirement Income You Need?

My recent articles featuring bucketed retirement portfolios--both traditional mutual fund and exchange-traded fund versions--sparked many insightful comments. The bucketing concept has resonated with many retirees and pre-retirees because it helps turn a portfolio geared toward accumulation into one that provides in-retirement income. It also enables a retiree or pre-retiree to back into a logical stock/bond/cash mix given his or her time horizon.

An essential first step before creating any retirement portfolio--bucketed or otherwise--is to determine whether that portfolio can deliver the income you need from it. Coming up with a safe withdrawal rate--the amount that you can withdraw from a portfolio per year without depleting it during your lifetime--is an essential part of the retirement planning process and has been the subject of much discussion among Morningstar.com readers. Retirement calculators can help you get your arms around whether your planned withdrawal rate is reasonable, but you can also run the numbers yourself, thereby employing the withdrawal rate method of your choice. Here are the key steps to take.

1) Determine the Paycheck You Need From Your Portfolio
If you're attempting to create the equivalent of a paycheck from your portfolio, the first step is to gauge your income needs during retirement, either on an annual or a monthly basis. Start by tallying your total expenditures, then subtract steady sources of income that you can rely on, including Social Security and pension income. What's left over is the amount that you'll need to extract from your portfolio each month or each year.

2) Choose Your Distribution Method
Next, determine the strategy you'll use for extracting the money from your portfolio. Among the most popular methods are the income-only approach, whereby you subsist on whatever income your holdings kick off; the fixed-percentage method, whereby you withdraw a fixed percentage of your portfolio per year; and the fixed-dollar amount plus inflation adjustment method, which is the approach underlying the 4% rule for retirement portfolio withdrawals. These approaches all have pluses and minuses. This article provides an overview of the various strategies; in this video, Morningstar Investment Management's director of retirement research David Blanchett discusses the results of his stress test of the various strategies.

3) Check Its Viability
If you're using the income-only approach, you can test the viability of your strategy by looking at the income your portfolio currently kicks off and comparing that amount to your desired income level. Of course, the income you're receiving today might not be there tomorrow, but with bond and dividend yields as low as they are, it's not unreasonable to use today's yields as a proxy for future income distributions.

If you're using the fixed-percentage method, the beauty of the strategy is that you'll never run out of money, so sustainability isn't an issue. But livability is: Under the fixed-withdrawal method, your income will fluctuate from year to year depending on how your portfolio performs. If the initial withdrawal amount is reasonable and you're comfortable with the uncertainty of a fluctuating income stream, then such a method is a good fit.

If you're withdrawing a level dollar amount from your portfolio per year, you'll have the peace of mind of a predictable income stream. But you'll first need to evaluate whether your desired portfolio withdrawal amount is too large or just about right. One widely used rule of thumb is that an initial withdrawal amount of 4% of your balance, combined with annual upward adjustments to accommodate inflation, is a safe withdrawal amount. This article uses a worksheet to walk you through some of the key variables, but it's helpful to sample an array of opinions on this all-important important topic. For another check,  Morningstar's Asset Allocator tool, T. Rowe Price's Retirement Income Calculator, and Fidelity's Retirement Income Planner can help you determine whether your current portfolio can deliver the dollar amount you need during retirement. (Just bear in mind that some of these tools are using fairly rosy return expectations for stocks.)

A version of this article appeared Dec. 10, 2012.

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