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Don't Let Bad Math Ruin Your Retirement

Congratulations -- you're a stock market genius! During a lifetime of smart investments, you scrimped and saved your way to a portfolio worth more than $1 million.

Now you're 55 and ready to retire to a sunny island, take the occasional trip to see the grandkids, and still have plenty in the bank to handsomely tip the caddies after they help you birdie that par five.

No problem ... if you've run your numbers right. But do you have any idea how much you can withdraw from your portfolio to make it all happen?

The price of the good life
If a 10% withdrawal rate sounds reasonable to you, I hope you're ready to go back to work. If the market doesn't perform up to snuff, you could deplete your savings in a mere 15 years. That means that at the age of 70, you could be looking for work again, in a market where your skills have one-tenth of their former value. That's not the retirement you hoped for when you said goodbye to the rat race, but it's the retirement you'll get if you fail to prepare and follow a sound financial plan.

A great retirement starts with a solid financial plan in place from the first day of your working life. That said, it's never too late to start planning. Putting together a complete financial plan that determines intelligent asset allocation, manages taxes and fees, calculates responsible withdrawal rates, and accounts for rising costs of living will still put you ahead of the majority of Americans.

Even master investor Peter Lynch wasn't fully ready for the future in 1995, when he wrote that a 7% annual withdrawal rate would be prudent for an all-stock portfolio. He later retracted his analysis when financial columnist Scott Burns proved that Lynch's strategy could make for a most unhappy ending.

Prepare your portfolio
Before you hit the beach, make sure your portfolio has some cover. Consider paring those stakes in volatile winners such as China Finance (Nasdaq: JRJC  ) , Force Protection (Nasdaq: FRPT  ) , Echelon (Nasdaq: ELON  ) , and Alnylam Pharmaceuticals (Nasdaq: ALNY  ) . Although each of these stocks has more than doubled over the past year, they also sport one-year betas greater than 2, and they have precipitously dropped in the past -- characteristics that investors with short timelines should avoid.

Now, consider reallocating a portion of that newly freed capital to blue-chip dividend-payers such as McDonald's (NYSE: MCD  ) or Kellogg (NYSE: K  ) , or an index tracker like the Fidelity Spartan 500 (FUND: FSMKX  ) . Unlike the volatile four mentioned above, McDonald's is a relatively stable boat with more than 50 years of history, an increasing dividend, and a strong operating track record.

But since there's no reason for a near-retiree to hold more than 60% of his or her portfolio in equities, just stash the rest in a healthy mix of bond funds such as the Bill Gross-run Managers Fremont (which recently received the Motley Fool Rule Your Retirement stamp of approval) and Treasury Inflation-Protected Securities (TIPS).

Now for the all-important withdrawal rate. You'll want to draw down your IRAs, 401(k)s, pensions, and other retirement accounts in a way that funds your retirement lifestyle and preserves your net worth. Financial planner William Bengen first showed -- and history has confirmed -- that a 4% annual withdrawal rate is a great place to start. But you'll also want to know which accounts to draw down first, ways to avoid big tax hits, and how to keep pace with the government's minimum distribution requirements. After all, those devilish details are what retirement planning is all about.

Be your own money manager
Preparing for retirement can be a complicated business -- even for great investors -- if you don't put together a proper plan. Running the numbers and experimenting with different withdrawal scenarios will take the guesswork out of your future, helping you avoid that dangerous scenario where you run out of cash.

No matter how complicated it gets, always remember that you are the best manager of your own money. You have your own best interests at heart, you won't charge yourself fees, and you're willing to devote every minute of your time to your future. That puts you ahead of most "professional" money managers from the get-go.

But even the most Foolish Fools need some retirement help, which is why we keep former Wall Street financial planner Robert Brokamp around. To start building your plan, try a 30-day free pass to Robert's Motley Fool Rule Your Retirement newsletter service.

You'll enjoy access to all back issues (including the special three-year anniversary issue), interviews with expert money managers, retirement calculators (including one for withdrawal rates), how-to guides, and the Fool's dedicated discussion boards. And if you sign up today, you can participate in the eight-lesson "How to Plan the Perfect Retirement" online seminar, which begins Oct. 8. Click here to learn more. There is no obligation to subscribe.

This article was originally published June 30, 2005. It has been updated.

Tim Hanson does not own shares of any company mentioned. No Fool is too cool for disclosure.


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