Confusion abounds over 'safe' withdrawals

Q. You confused me recently in a column about safe rates of withdrawal. I am 68 years old and 80 percent invested in CDs. My CDs are paying between 5 percent and 5.5 percent. If I withdraw only 4 percent or 5 percent from my investments, I will have more money when I die than I have now.

It seems to me that I should withdraw all of my interest each year as well as about 4 percent of my principal, or about 9 percent total.

If I buy an immediate life-only annuity, it will pay me 9.2 percent for the rest of my life -- something I cannot outlive. So why do many financial advisers recommend only 4 percent to 5 percent? -- G.W., by e-mail

A. It's confusing, isn't it? It's particularly confusing when you can earn more in current interest. The distinction, however, is that the 4 percent to 5 percent safe withdrawal rate is calculated under the assumption that you will increase the annual dollars withdrawn to compensate for inflation. As a result, you'll have constant purchasing power throughout your life. You won't get that from a CD.

The same calculations estimate the value of your assets at death. They estimate the safe withdrawal rate based on the idea that the worst case is that you might die with less money, but you would not die broke. So your assets at death will be greater than zero.

Your CDs don't allow for that. If you reserved 3 percent for inflation, you'd have only 2 percent to 2.5 percent annually to spend -- and this assumes the CDs are in a tax-deferred account. If you spend the full payment, your purchasing power will diminish as you age, but you will have assets at death equal to what you now have (except the dollars will have much less purchasing power).

It's the same with a life annuity. It will provide you with the same monthly check until you die. But the purchasing power of that check will decline each year with inflation. If you got a quote on an inflation-adjusted life annuity, the annual payment (as a percent of original investment) would be well under 9 percent, and a portion of the excess over 4 percent to 5 percent would be considered return of principal. Your assets at death would be zero.

All three paths -- portfolio with safe withdrawal rate, life annuity or inflation-adjusted life annuity -- are different ways of coping with having an income in retirement and the possible spending down of assets. It's not a trivial problem.

You should know, by the way, that there is a very vocal group on the Internet that believes the 4 percent to 5 percent withdrawal rate rule is far too high most of the time.

They believe, following research originally done by Steve Leuthold and renewed later by Rob Arnott, that future stock returns depend on the price-to-earnings ratio of stocks at the time you start. Retire in a high P/E period -- like 1972 or 1999 -- and the odds of portfolio survival decline because future returns are likely to be poor. Retire in a low P/E period -- like 1981 -- and the odds of portfolio survival soar because future returns are likely to be high.

I regularly suggest a 4 percent to 5 percent withdrawal rate because it's still a good rule of thumb for all but the most extreme periods of over- and undervaluation. The only truly safe withdrawal rate that will guarantee that you die with an amount of purchasing power -- not dollars -- equal to what you retired with is the premium over inflation paid on a portfolio of Treasury Inflation-Protected Securities. That's about 2.4 percent.

It's also a bit lean for all but the very wealthy. So it all comes down to taking some amount of risk to earn a higher return. The only alternative is to convert some of your assets into a life annuity. Then an insurance company takes the risk.

© 2007, Universal Press Syndicate