Running out of money in retirement is one of the biggest financial fears savers tend to face. But what if you could ensure that that would never happen?
Technically, it's possible. If you pledge to live off of your portfolio income only in retirement, you can avoid touching your principal, thereby guaranteeing that your 401(k) or IRA won't run out on you.
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It's a good idea in theory. In practice, it may be difficult to pull off.
Income-only versus the 4% rule
One popular strategy for managing a retirement nest egg is to use the 4% rule for withdrawals. That rule has you withdrawing 4% of your savings balance your first year of retirement and adjusting future withdrawals for inflation.
Living on portfolio income only in retirement isn't the same thing as following the 4% rule. With the 4% rule, you may be withdrawing a combination of principal and interest to address your income needs. If you live on portfolio income only, you're only touching the gains portion of your retirement account, not the principal.
Put another way, even if you use the 4% rule, your savings could run out over time. If you never touch your portfolio's principal, it can't decrease, and your nest egg therefore can't get depleted.
There are pitfalls involved
You may like the idea of only touching the income portion of your portfolio in retirement and leaving the principal alone. But this is a very tricky approach to pull off. For one thing, it may require you to have a lot of money.
Let's say you need $100,000 a year to live comfortably once you stop working, and Social Security provides $40,000. To get $60,000 a year out of your portfolio, you might need $2.4 million.
Where does that number come from? An income-only approach may require you to invest your money pretty conservatively in retirement. If so, it may be reasonable to assume that you can safely get a 2.5% annual return on your money. To get $60,000 a year, you'd therefore need $2.4 million, which is a lot of money to accumulate, even if you start saving at a pretty young age.
In addition to needing a lot of money to pull off this strategy, you need inflation to work in your favor. And that may not happen.
If you're able to cover your expenses on $60,000 your first year of retirement, chances are, by the time you enter your fifth or sixth year, you'll need more than $60,000 to cover the same set of expenses. At that point, you'll have a choice -- touch the principal portion of your portfolio, take on more risk with your investments, or cut back on spending to stick to your plan.
Should you try to live on portfolio income only?
The peace of mind that comes with knowing you're not touching your portfolio's principal is hard to beat. And if leaving a legacy for your heirs is important to you, an income-only approach protects your principal, allowing you to pass a potentially huge sum of money along to the people you love.
But these benefits come at a cost. Not only do you need to push yourself to save a lot of money to be able to live on portfolio income alone, but you may need to limit your spending in retirement to avoid touching your principal. That could mean not getting to do all the things you've wanted and can actually afford.
Also, to generate enough consistent income through the years, you may need to err on the side of conservative investments in retirement. That could mean giving up potential gains in your portfolio.
This isn't to say that an income-only approach to managing your portfolio doesn't make sense or won't work for you. If you have enough money, you can certainly try it.
The point, however, is that this strategy is far from easy to utilize. And if you lock yourself into it, you could end up underspending during retirement and denying yourself some of the experiences you've earned the right to enjoy.
