You’ve worked hard and saved and invested carefully for decades. Retirement is on the horizon. Now, the challenge lies in figuring out how to use your nest egg. The goal is to withdraw enough to live comfortably, but not so much that you run out of money before you die. It’s a highly personal decision that depends on factors you can only guess at: how long you’ll live, what kind of medical expenses you’ll incur, how your investments will perform and what the inflation rate will be.

Assessing Your Resources and Needs

Any analysis of how to use your retirement savings must start with an evaluation of your retirement income and expenses. For income, most people will receive Social Security and some people will receive pensions. An annuity or a rental property may provide another source of income for some retirees, as may investments you've made, such as stocks or real estate – either through a qualified retirement plan, such as a 401(k) or in a separate investment account.

If you're entitled to a pension, your employer should be able to tell you what monthly payment to expect, and the Social Security website can give you an estimate of your Social Security benefit payments (it can’t tell you what your actual monthly payment will be until you apply for benefits). Your brokerage and similar statements can help you estimate income from investments. Some people will also have income from part-time work, especially in the early years of retirement. (See Why to Start Your Own Business During Retirement and our Starting a Small Business tutorial.)

For expenses, you’ll need to review your spending for the last one to two years. If you don’t regularly track your spending, this task can be tedious, as it involves going through bank and credit card statements and categorizing each expense so you know what you spend on groceries, utilities, gas, car maintenance, healthcare, travel and so on. A budgeting program like Mint or Quicken can make the process less painful by automating the aggregation and categorization tasks. It’s also helpful to categorize your expenses by essential and nonessential, and consider whether any of your expenses are likely to increase or decrease after retirement.

The 4% Rule

The portion of your expenses that your income sources won’t cover must come from your retirement savings, but you can’t simply withdraw the amount of your expenses each year. If you’ve done any research on retirement drawdown strategies, you’ve probably heard of the 4% rule, perhaps the best-known strategy, developed by financial planner Bill Bengen in the 1990s.

The 4% rule says you should withdraw 4% of your retirement portfolio balance in year one, then adjust that dollar amount in subsequent years based on inflation. If your portfolio is worth $1 million, for example, you would withdraw $40,000 in year one. In year two, if the inflation rate is 3%, you would withdraw $40,000 plus 3% of $40,000, for a total of $41,200. This strategy is supposed to give you a 90% chance that your portfolio will last for 30 years, assuming your portfolio has a 50% allocation to stocks and a 50% allocation to bonds. 

If your budget analysis reveals that you’ve been spending more than $40,000 a year (over and above your income sources), the first thing you’ll have to do to make sure your drawdown strategy is sustainable long term is figure out where to cut back or how to earn more.

The 4% Rule, Modified

The 4% rule is still a good starting point, but blindly following it regardless of your personal situation or market circumstances can leave you with too much or too little in your portfolio over time. Making small adjustments each year as things change may be a better strategy.

Certified financial planner Kevin Gahagan, principal and chief investment officer with Mosaic Financial Partners in San Francisco, describes how this plan works. You still start with a 4% withdrawal in year one. In subsequent years, if the markets have risen a bit – say, 5% – you increase your withdrawal amount by the rate of inflation. If the markets have fallen somewhat, you don’t give yourself an inflation increase. If the markets have fallen substantially – 10% to 15% – you reduce your withdrawal rate. And if you have a home run year and the markets go up 20%, you can give yourself an inflation increase plus a bit extra.

The idea behind this strategy is that it lets you maintain a consistent standard of living from year to year while making sure your portfolio will last long term despite the market’s ups and downs. And you don’t have to spend the full amount you withdraw each year; you might want to set some of it aside in a liquid reserve for years when you need to withdraw less or spend more, Gahagan says. 

This withdrawal strategy is based on having enough money to last your lifetime, which might mean completely spending down your portfolio, Gahagan says. It doesn’t assume that you’ll end your life with a large portfolio balance. 

A different plan with a lower withdrawal rate may therefore be in order if you want to leave a large inheritance. And if you want to use a higher initial withdrawal rate than 4%, it becomes even more important to monitor the assumptions you’re operating under. 

Also, your asset allocation should affect your withdrawal rate. The fewer equities you have, the lower your withdrawal rate can be, Gahagan says. If your portfolio is 60% fixed income and 40% stocks, a 4% withdrawal rate is not realistic. But the solution is not an all-equity portfolio, either, because if there’s a severe recession and you’re forced to sell at a loss in the early years of your retirement, it can kill the sustainability of your portfolio, he says. 

Other Strategies

Does the modified 4% method sound too complicated? You could withdraw the same dollar amount from your portfolio each year, but this method doesn’t make sense unless you want to experience a declining standard of living as you get older. Inflation will make that flat dollar amount worth less each year in terms of what you can actually purchase with it. By the time you’re 25 years into retirement, if inflation has averaged 3% per year, your living standard will be cut in half if you never increase your withdrawals. Retirement Planning: Why Real Rates of Return Matter Most gives the details.

You could also withdraw the same percentage of your portfolio each year, but this means ignoring market conditions. This may increase your risk of spending your nest egg too slowly or too quickly. You also end up with a less consistent annual income, since 4% of your portfolio in a year when the markets are soaring will be much more than 4% during a market downturn. 

If you’re not sure you’ve saved enough for your portfolio to sustain you throughout retirement, you might want to start off with a very conservative withdrawal strategy, possibly supplemented by income from part-time work. The extra money you’re leaving in your portfolio will have more years to grow and compound, making it more comfortable to withdraw more later. If, however, your retirement plans include potentially pricey endeavors like traveling early in retirement while your health and energy levels are likely to be better than they will be later, penny pinching early on won’t be an appealing strategy.

“Traditional sustainable withdrawal strategies range from 3.7% of principal from Merrill Lynch Wealth Management, to sustain 25 years of withdrawals in a 60% stocks, 40% bond portfolio, to more than 5% from insurance company–sponsored products, like annuities with living benefits,” says chartered financial consultant Paul T. Murray, president of PTM Wealth Management in Chalfont, Pa. 

Figuring out a safe withdrawal rate isn’t rocket science or brain surgery, Gahagan says, and it is something most people can do on their own with the help of high-quality online calculators and tools. Still, a lot of people don’t feel confident in their ability to understand or work with numbers, Gahagan says, and for those people, as well as anyone who’d simply prefer to have an expert handle the task for them, it makes sense to work with a financial professional. 

The Bottom Line

Overall, the best retirement withdrawal strategy is one that considers health, life expectancy and inflation, Murray says. “A best practice would be to review that drawdown strategy annually to assess the previous year’s investment performance and prevailing interest and inflation rates.”