Personal Finance: Watching withdrawals is a key to retirement

People feel fragile after watching, during the financial crisis, a vicious bear market destroy half the money they had in the stock market.

Twice in the last decade, stocks ravaged savings, destroying 49 percent in the stock market in 2000-02 and then 57 percent in the 2007-09 crisis.

People now realize they can diligently save throughout their lives and lose an essential chunk of savings when it is needed most, just before retiring or during retirement.

Yet the last decade also provides some reassurance. Despite one of the worst decades in stock market history, retirees who had balanced portfolios of roughly half stocks and half bonds, and quickly altered their spending just a bit when stocks plunged, have bounced back. It simply required paying attention to how much money a person withdraws from savings each year.

It's an approach that financial planners have long claimed would work. Using T. Rowe Price's database, I examined results from the harsh last decade.

I assumed that a person had a $500,000 nest egg and retired just before the 2000 stock market plunge. At the time, the person probably would have been feeling pretty confident about the future. For two decades, stocks had been climbing on average 17.8 percent a year.

Nearing retirement, the person might even have flirted with the idea of taking greater risks with the nest egg than investing 55 percent in stocks and 45 percent in bonds. Yet that mixture is a common moderate suggestion for those near retirement.

According to a rule of thumb, retirees can make their savings last for 30 years of retirement if they withdraw no more than 4 percent of their savings the first year of retirement and then increase the sum just 3 percent a year to cover the effect of rising prices. In other words, with $500,000 in savings at retirement, a person can withdraw $20,000 the first year after leaving work to cover annual expenses. The next year: $20,600.

T. Rowe Price examined the rule of thumb by running thousands of market scenarios through what is called Monte Carlo computer simulations. A person who retired in January 2000 with $500,000 in savings and invested 55 percent of it in stocks and 45 percent in bonds would have been 89 percent sure of having enough money for 30 years in retirement.

However, the last decade shows that simulations can lead people astray. By September 2002, the person who had retired so confidently in 2000 would have had only a 46 percent chance of making the money last; the harsh reality posed after the 2000-02 debacle destroyed almost half the money invested in the stock market. And after getting hit again in 2007-09, the once-confident retiree had a 94 percent certainty of running out of money fairly early.

Market downturns early in retirement can decimate savings faster than average returns imply.

The combination of stock market losses and depleted savings presents risks for retirees that do not exist for people earlier in their work lives. After the horrible last decade, the person who retired in 2000 at age 65 would have had just $334,578 left at the end of 2010.

What to do?

A fairly simple strategy worked, said Christine Fahlund, a T. Rowe Price financial planner. People should have changed their plan for withdrawing money from savings. Instead of increasing the amount of spending money for inflation, T. Rowe Price found that simply freezing increases - or not taking the usual raises to cover inflation - between 2002 and 2005 would have helped preserve money and allowed the portfolio to heal as the market regained strength.

Withdrawals also would have been frozen between October 2007 and March 2009.

People who adjusted withdrawals would now be 70 percent sure that their money would last through retirement, according to the T. Rowe Price simulations.

To test potential outcomes for your savings, try this calculator: troweprice.com/ric.