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.

In later analysis, Bengen applied a "floor-and-ceiling" withdrawal technique that reflected market conditions and how people would likely react to them. In bull markets, retirees could make withdrawals up to 25% greater than the initial withdrawal rate. In bear markets, withdrawals can decline as much as 10% less than the first-year rate.

Applying this method to a portfolio with 63% large-cap stocks and 37% intermediate-term government bonds, Bengen found that an initial withdrawal rate of 4.58% produced a 100% chance that the money would last for 30 years. At an initial rate of 5%, the portfolio had a 91% chance of lasting 30 years. At an initial rate of 5.25%, the odds decreased to 80%.

Bengen says he recommends a 4.5% to 5% initial withdrawal rate for most of his clients, with later adjustments in yearly withdrawal levels when market conditions require it. He suggests a 4% rate for conservative clients. "I get a little queasy and have to reach for the air bag when withdrawal rates get above 5%," he says.

Bengen's results are slightly more aggressive than a 1998 study conducted by three professors at Trinity University in San Antonio, Texas.  The Trinity study measured various withdrawal rates and asset allocation models between 1926 and 1995 to gauge how successful various rates were at sustaining portfolios over specified time periods.

When adjusted for inflation, 3% withdrawal rates on stock-heavy portfolios (between 50% and 100%) were 100% successful at maintaining assets for 30 years, while 4% withdrawal rates achieved success in the mid-to high-90% range depending on the stock allocation. A 100% bond portfolio had only an 80% success rate for 30 years.

These studies jibed with Harvard University research in 1973 that found that a 4% withdrawal rate on a portfolio with 50% stocks and 50% bonds-with subsequent withdrawals adjusted for inflation-could support its endowment fund without draining the principal.

So there it is: 4% or so seemed to be the magic number. Not so fast, though, because recent research ratcheted up the debate on withdrawal rates after certified financial planner Jonathan Guyton issued a paper last autumn that loosened the purse strings on retirement account spending.

By following a few rules, he says a portfolio with 80% stocks can support a 6.2% initial withdrawal rate while an allocation with 65% equities can sustain a 5.8% rate over 40 years. As for the rules, they are as follows: 1) Generate cash and rebalance a diversified portfolio by selling winning funds; 2) Cap annual withdrawal rates at 6% regardless of inflation; 3) Withdrawals aren't increased after a year of negative investment returns.

Guyton's research is based on the years 1973 to 2003, a period that included two nasty bear markets and a period of sustained high inflation. "I've had advisors tell me that for years they've had a hunch that the safe withdrawal rate was higher [than 4%-4.5%]," says Guyton, a principal at Cornerstone Wealth Advisors in Minneapolis.

Others aren't so sure. Kathleen Cotton, president of Cotton Financial Advisors in Lynnwood, Wash., recom-mends a 4% withdrawal rate for clients whose portfolios are less than half in equities. She provides more latitude for clients with at least 50% stocks, although she says she gets nervous when the rate gets up to 6%.

Cotton is wary of studies that recommend initial withdrawal rates of 4%, followed by inflation-adjusted increases in subsequent years. "I'm never going there," she says. "People can do studies until they're blue in the face, but if a client is taking out a steady rate of money each year and then the portfolio drops due to poor market conditions, then something has to give," she says.

When markets go south, Cotton advises clients to generate cash by tapping maturing bonds as opposed to liquidating equities. And she stresses to her clients the need to trim their distributions or else face the prospects of potentially running out of money during their projected lifetime.

"It's the client who ultimately decides what they want to do," says Cotton. "I'll tell them it's dangerous if it gets too high, but they're adults so I can tell them only so many times. I'm not their mother."

Clients might not like that advice, but Cotton doesn't waver from her belief that it's better to underlive one's resources in order to prepare for surprises down the road. "If we end up dying with money in our pocket, then so be it," she says. "It's better than worrying about running out of money in our lifetime."

Cotton's uneasiness toward pre-scribed withdrawal rates is shared by others. "I don't think withdrawal rates fit into the real world of clients' lives and I think they're misleading," says William Starnes, partner at Mallard Advisors, a financial planning firm in Newark, Del. "I don't think it's realistic to take mandated inflation-adjusted withdrawals because life isn't fixed. Other income sources start and stop, and expenses come and go."

Starnes does a lot of cash flow retirement projections for soon-to-be retirees, and if they're relatively young he factors in starting dates for pensions and Social Security benefits. He believes that setting initial withdrawal rates sets a pattern that encourages clients to take money from their retirement accounts that they don't need. 

Take, for example, a 60-year-old recent retiree. The client needs to take larger withdrawals during the first five years of retirement until other income sources kick in. Once that money starts flowing, it's assumed she should cut back on withdrawals from her retirement account. But by setting an initial withdrawal rate and getting locked into a pattern of yearly withdrawals based on inflation-adjusted increases, the client might get into the habit and unnecessarily deplete her retirement portfolio.

Starnes' cash flow projections take into account future expenses such as potential health care costs or, for younger retirees, college expenses. He's mindful that pensions don't last forever and that Social Security benefits get halved when a spouse dies. "It's not the withdrawal rate that's important," he says. "Clients are primarily concerned with cash flow needs and maintaining a certain lifestyle over time."

Starnes notes that some clients require larger early portfolio withdrawals followed by smaller withdrawals in later years. Others might require the opposite scenario.

In addition, Starnes feels that formulated withdrawal rates ignore tax planning needs. Let's say a person in a lower tax bracket qualifies for a $50,000 withdrawal but can comfortably get by on significantly less. Starnes argues it makes no sense to take the higher distribution because it would provide more money than needed while also bumping that person into a higher tax bracket.

Some advisers believe the concepts of withdrawal rates based on historical models make for great talking points, but ultimately should be taken with a grain of salt. "It's like a military strategy game where you're winning wars that were fought and not those that will be fought," says David Diesslin, a principal with the financial planning firm Diesslin & Associates in Fort Worth, Texas.

For Diesslin, handling retirement account distributions is as much an art as it is a science. The art comes from knowing your clients and understanding their fears and needs. Retirement can be scary for many people, because their success is no longer based on their ability to earn but rather on the ability of their assets to earn. "Most people want a run rate they can count on and not have to go back from under normal circumstances," Diesslin says. "But it's not that big a deal for people who are prepared for it."

And that's where the science comes in. Like many advisors, Diesslin uses Monte Carlo analysis tools to build a model that accounts for numerous potential variables that could affect a client's portfolio in the future. He believes these metrics help clients better understand the limitations of their portfolios, and that in turn helps them deal more confidently with the unknown. It also helps them adjust their spending to the realities of current market conditions.

But Monte Carlo is useful up to a point, says Michael Dubis, president of Touchstone Financial in Madison, Wisc. "It gives you thousands of variations, but there are infinite variations that can happen," he explains. "How can you cover infinite variables?"

Because possible future events are boundless, Dubis sticks to withdrawal rates of 3% to 5%, with a preference for rates that are 4% or under. "I don't think I'm being conservative," he says. "I think I'm protecting against the opportunity cost of being wrong."

According to both Bengen and Guyton, withdrawal rates aren't necessarily market neutral because they can be manipulated slightly to accommodate varying conditions. But extreme markets can skew perceptions about what's an appropriate rate, as Ray LeVitre discovered during the late-1990s boom years.

LeVitre, a certified financial planner with Net Worth Advisory Group in Salt Lake City, had some clients who retired early during those heady days and took their 72(t)  IRA early distributions at one of the two higher rates allowed. "I got caught up in the market in '98 and '99 and I didn't put my foot down enough when they spent too much," he says.

He set withdrawal rates of 7% to 9% in a couple of cases. After the market crashed, the IRS gave people the option to make a one-time change to their 72(t) rates, and LeVitre adjusted those clients down to a lower distribution rate. "I think we all learned from the experience," says LeVitre, who adds that he partly relied on the faulty math used by Peter Lynch.

These days, LeVitre sets withdrawal rates by plugging clients into a financial planning calculator on software he owns, and he uses Monte Carlo to gauge various probabilities based on various withdrawal rates.  In most cases he and his clients are comfortable with likely success rates of 85% or more that the money will last for 30 years, and the initial withdrawal rate usually falls between 4% and 5%.

Like many planners, Armond Dinverno of Balasa Dinverno & Foltz in Illinois approaches withdrawal rates by asking clients a simple question: What do you want your retirement to look like?

He then takes into account their age, portfolio size, spending needs, risk tolerance and expected longevity. He'll run that information through a Monte Carlo analysis, and his clients typically fall into the 2% to 6% range for an initial withdrawal rate. He personally favors a 4% rate in most cases. "Setting a withdrawal rate gives me a roadmap for the next 30 years," Dinverno says. "But we re-evaluate things every three or four years because there are always external pressures on a portfolio."

Dinverno had one client who retired at 60 and made it clear that he wanted to enjoy life and not hold back. Based on the client's call, his withdrawal rate came to 11%. It remained that way throughout the go-go 1990s, although Dinverno often reminded the client that a sustained bear market would hammer his portfolio and require a spending reduction.

When the market tanked in 2000, Dinverno got his client to cut his withdrawal rate to 7%. Although that's still too high for Dinverno's liking, there's not much he can do about it. The man is 73 and his money should run out in 15 years under current projections. "This client is comfortable with that," says Dinverno. "Other clients would never go near that."

For Dinverno, the beauty of withdrawal rates is that there is no right answer because it's different for every client. "I think the research going on and the sharing of different approaches is great for the profession."

Jonathan Guyton hoped to foster such discussion when he published the results of his research relating to his 6% withdrawal rate formula in The Journal of Financial Planning. He thought prior research on the topic had shortcomings, such as relying on static pro-rata portfolio withdrawals based on asset allocation rather than asset performance. He also believed that their reliance on automatic inflation-based yearly increases was unrealistic because it ignored the fluid nature of market conditions and how people react to them.

So Guyton devised dynamic rules (the aforementioned three decision rules) that mimic actual advisor and client behavior. For instance, Guyton notes that most people naturally tighten their belts after a bear market. Consequently, he says his rule stipulating that retirees hold the line on withdrawal increases after a year of negative returns is just common sense.

As for his research, Guyton chose 1973 as a starting point because it coincided with the 1973-1974 bear market and the start of a 10-year run of nearly 9% average annual inflation. In doing so, he wanted to prove that his withdrawal rate calculation could withstand "perfect storm" conditions like everything that happened between 2000 and 2002.

But Guyton realizes his calculations aren't foolproof, because there's always the chance for even greater perfect storms. "Hypothetically, there can be even worse scenarios where my numbers won't stand up," he says.

Ultimately, Guyton agrees that there are no magic bullets. "The issue of withdrawal rates is a critical one that's still evolving," he says. "I hope I've contributed a better understanding of the question and some of the nuances than can affect the answers."