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the long view

When it comes to planning a secure retirement, people want The Answer.

Problem is, when they get it, they hate it.

The 4-per-cent rule is as close to a universal law as there is in financial planning. It says that retirees who don't want to run out of money and are planning for 30 years of life after work should restrict themselves to withdrawing no more than an inflation-adjusted 4 per cent a year of their original portfolio.

To be sure, the 4-per-cent rule isn't as fixed as the boiling point of water or the speed of sound, but it is based on a mountain of historical and statistical evidence that suggests the chance of you exhausting your portfolio rises sharply as your withdrawal rate exceeds this speed limit.

Despite its solid foundation, people detest the rule – and for good reason. It's less than exhilarating to think you will have to amass a million bucks to generate a paltry $40,000 a year in retirement income.

So let's take a closer look at this rule, read the fine print, and see where the loopholes might be.

A good place to start is by understanding the guideline. Many people skip over an important but easy-to-miss little twist – the inflation-adjusted nature of the withdrawals.

If you have a million-dollar portfolio, you withdraw $40,000 in the first year of your retirement. The following year, you bump up your withdrawal by the amount of inflation – say, 2 per cent – and take out $40,800, no matter how your portfolio has fared in the interim.

Ten years after you retire, assuming inflation continues to tick higher at the same rate, your annual withdrawal grows to $48,759. Twenty years after you retire, it's up to more than $59,000.

Suddenly the 4-per-cent rule doesn't look quite so stingy.

Unfortunately, the rule doesn't take into account the minimum withdrawal requirements from registered retirement income funds (RRIFs).

It also falls far short of the aspirations of many avid investors who figure their portfolios can be counted on to produce returns that will be much higher than the measly withdrawals.

So what happens if you exceed the 4-per-cent ceiling? The world doesn't immediately explode.

Rather, your chance of running out of money rises. Keep your withdrawals within limits, however, and you will probably be okay.

The question is how much you want to bet on that "probably." Moshe Milevsky, a professor at York University, calculates the chances of financial ruin in his book The Calculus of Retirement Income.

He shows that a 65-year-old investor who has a stock portfolio with an expected return of 7 per cent a year runs about a 9.4 per cent chance of running out of money in retirement if he or she sticks to a 4-per-cent withdrawal rule. (This assumes the stock portfolio is roughly as volatile as the overall market.)

If he or she bumps up the spending rate to 5 per cent, the probability of running out of money shoots up to nearly 17 per cent. Raise the withdrawal rate a notch higher to 6 per cent and there is slightly more than a 25 per cent chance of your portfolio expiring before you do.

Some people will look at those probabilities and conclude they can withdraw more than 4 per cent a year. Others will reach the opposite conclusion.

Before arriving at your own decision, keep in mind that achieving a given rate of return may be tougher than you think.

Most people's expectations of a reasonable return were shaped by the past couple of decades, in which investors' profits received a big boost from high bond yields.

With safe government bonds now producing pitifully small yields, the overall return you can expect from a balanced portfolio of both bonds and stocks has shrunk accordingly. As a result, a study last year by investment research firm Morningstar argued the 4-per-cent rule should be replaced by a 3-per-cent rule.

Ouch. The good news is that bright people have been working to find reliable ways to tease more money out of retirement portfolios. In future columns, we'll look at a couple of the leading strategies.