Do you understand all the assumptions you are making regarding withdrawal rates?

    The New Yorker once ran a cartoon of a man in a chair working on his laptop computer while surrounded by boxes of paperwork. He looked at his wife as she stood nearby and said, "If we take a late retirement and an early death, we'll just squeak by."

This little chuckle addresses one of the most serious issues in financial planning: ensuring that clients have enough money to last their lifetime. "It's one of the most crucial issues of our time when you consider all of the people who are at or are looking at retirement in coming years," says Michael Williams, president of Altius Financial, a registered investment advisory firm in Denver.

In many ways, managing a nest egg to last a lifetime is more difficult than building one in the first place. People have been retiring earlier and living longer. They don't want to run out of money but they don't want to live like ascetics, either. Pensions and Social Security aren't the safety nets they used to be, because the former has essentially been displaced by defined contribution plans and the latter faces an uncertain future.

Inflation and market performance can be either friend or foe to a retirement portfolio, and poor planning can lead to irreversible damage. Saving for age 65 is one thing, but budgeting for unknown longevity is another. "Retirement planning is a balancing act that each client feels differently about," says Armond Dinverno, co-president of Balasa Dinverno & Foltz LLC, a wealth management firm in Itasca, Ill.

It's a subject that financial advisors also feel differently about, with varying opinions about setting proper withdrawal rates and how to achieve them.

One of the more simplistic approaches was floated by mutual fund legend and eternal optimist Peter Lynch in the mid-1990s. Based on historic average returns on stocks of roughly 10% to 11% since 1926, he suggested that a portfolio fully invested in equities could support 7% annual withdrawal rates, adjusted for inflation, without draining assets. Problem is, market fluctuations such as the 2000-2002 bear market would decimate a portfolio using that strategy.

It was El Cajon, Calif.-based financial planner William Bengen who helped frame the issue for the industry, beginning in 1994 with a series of papers that pegged the so-called safe withdrawal rate as one that 100% guarantees a retirement account will remain solvent for 30 years. His solution called for choosing an appropriate initial withdrawal rate, and then increasing each subsequent yearly withdrawal by the inflation rate. The initial rate must be small enough to accommodate future increases, but large enough to maintain a desired lifestyle.

Bengen suggested that stocks should comprise 50% to 75% of retirement portfolios, and that anything less than 50% and more than 75% was counter-productive. The equity allocation should be decreased by one percentage point per year each year during retirement.

Using historical market data, Bengen came up with 4.1% as a safe initial withdrawal rate for portfolios containing 50% to 75% equities in the form of S&P 500 stocks. The remaining portfolio comprised intermediate-term govern-ment bonds. For a beginning portfolio valued at $1 million, the initial withdrawal amount would be $41,000. Assuming a 3% inflation rate, the withdrawal in the second year would be $42,230, followed by subsequent yearly increases based on inflation.   

By infusing small-cap stocks into 30% of the equity portion of an ideal portfolio, the safe initial withdrawal rate increased to 4.3%. That's no trivial difference, he noted, since a few extra hundred dollars a month can help pad a comfortable lifestyle.