Don't Let Bad Math Ruin Your Retirement

Congratulations -- you're a stock market genius! During a lifetime of smart investments, you scraped 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 tip the caddies when they help you birdie that par 5.

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. It could happen in 15 years if the market doesn't perform up to snuff. At the age of 70, you could be looking for work again, in a market where your skills have one-tenth of the value they used to. 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 on day one 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. He wrote at the time that a 7% annual withdrawal rate would be prudent for an all-stock portfolio, but he 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. Pare those stakes in volatile winners such as SIFCO Industries (AMEX: SIF  ) , Alpha Natural Resources (NYSE: ANR  ) , Cepheid (Nasdaq: CPHD  ) , and Flotek Industries (NYSE: FTK  ) . Although each of these stocks has more than doubled over the past year, they also sport betas greater than 2 and have shown a tendency to precipitously drop -- characteristics that investors with short timelines should avoid.

Now consider taking that newly freed capital and reallocating a portion of it to blue-chip dividend payers such as 3M (NYSE: MMM  ) or Fortune Brands (NYSE: FO  ) or an index tracker like SPDRs (AMEX: SPY  ) . Unlike the volatile four mentioned above, 3M is a stable boat with more than 100 years of history, a consistent dividend record, and diverse products.

But since there's no reason for a near-retiree to hold more than 60% of his or her portfolio in equities, 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 while preserving 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 and help 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. Those plain facts put 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 get started building a financial plan, try a 30-day free trial to Robert's Motley Fool Rule Your Retirement service. You'll enjoy access to all back issues, interviews with expert money managers, retirement calculators (including one for withdrawal rates), how-to guides, and the Fool's dedicated discussion boards. Click here to learn more. There is no obligation to subscribe.

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

Tim Hanson owns shares of 3M, but no other companies mentioned in this article. The Motley Fool owns shares of SPDRs. 3M is a Motley Fool Inside Value recommendation. At the Fool, no writer is too cool for disclosure ... and Tim's pretty darn cool.

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