How much will you need to retire?

You need retirement income and are counting on your retirement accounts to be a money machine. The question is-how much can you take from the machine without breaking it? A recent study shows most upcoming retirees have little idea how much money they can safely withdraw.

Traditional calculations claim that you can spend about four percent of your investments each year and never run out of money. This means for every $100,000 invested, you would have $4,000 of annual retirement income.

The latest research, however, provides a different answer and a set of clear-cut rules to follow to give you the greatest probability for increasing your retirement income.

What happens if you follow the rules? You may be able to withdraw as much as six to eight percent of your initial portfolio value, or $6,000 to $8,000 a year, for every $100,000 you have invested.

So what are these rules?

Rule #1: Use a multi asset class portfolio for diversification

It's like eating a well-balanced meal. Imagine, for example, sitting down to a sumptuous dinner of steak, shrimp, and baby back ribs. Although the meal has variety, it is not well balanced.

In the investment world, instead of food groups, you have asset classes. A well-balanced portfolio contains at minimum an allocation to each of the following asset classes: Canadian equities, U.S. equities, international equities, real estate, and fixed income.

Rule #2: Maintain the right proportion of equities to fixed income

Many experts still believe that your portfolio must have a minimum equity exposure of 50 percent and a maximum equity exposure of 80 percent. In nutritional terms, think of this as healthy eating: a meal that has the right proportion of protein and carbohydrates.

If you fall too far out of this range, you could run the risk of running out of money. Too much in equities, and volatile markets could scare you away at the worst time. Too much in fixed income, and your retirement revenue will not keep pace with inflation.

It is best for the novice to seek professional advice as to the appropriate allocation.

Rule #3: Take withdrawals in a prescribed order

When you withdraw funds, your retirement income must come from each category in a particular order. For the new investor, these rules can be complex.

To simplify them, picture three buckets.

• Bucket number one is full of cash, enough to cover one year's living expenses.
• Inside bucket number two you stack your fixed-income investments. Each layer represents one year' living expenses. Every year, one year's worth of spending money matures and moves from the fixed income bucket to the cash bucket. This ensures that you always have enough cash on hand to cover future expenses.
• The third bucket is filled to the brim with equities. You may only take money from the equity bucket when it overflows. An overflow year is a year when equities produce above-average returns, roughly an annual return in excess of a high benchmark. At the end of an overflow year, you sell excess equities and use the proceeds to refill the fixed-income and cash buckets.

There will be years when the equity bucket does not run over. It takes discipline to allow the fixed income and cash buckets to get to a low level during this period. Eventually, an overflow year will come along and all buckets will be refilled.

Following this rule will prevent you from becoming a victim of your emotions and selling investments at an unfavourable time.

Rule # 4: Take a pay cut occasionally to preserve capital

To protect your future retirement income from erosion, the capital preservation rule functions as a safety net. It is triggered when your current withdrawal rate is 20 percent greater than your initial withdrawal rate. Sound confusing? The best way to explain this rule is an example:

Assume you have $100,000 and you start withdrawing seven percent or $7,000 each year. The market goes down for several years and your portfolio value is now $82,000. The same $7,000 withdrawal is now eight and one half percent of your current portfolio value. Since your withdrawals represent a bigger portion of your portfolio, the capital preservation rule kicks in, and says you must reduce your current year's withdrawal by ten percent. In this example, your withdrawal for the year would go from $7,000 to $6,300.

Much like in real life when some years you receive a bonus and other years a pay cut, this rule adds the flexibility you need to endure changing economic conditions.

Rule #5: Take a raise

The fifth and final rule is most people's favourite. The opposite of the capital preservation rule, it is called the prosperity rule. It states that as long as the portfolio had a positive return in the prior year, you may award yourself a raise. Your raise is calculated by increasing your monthly withdrawal in proportion to the rise in the consumer price index (CPI). If you were withdrawing $7,000 a year, the market had a positive return and the CPI went up by three percent, the following year you would withdraw $7,210.

Following these rules takes discipline. But the reward will be a higher level of retirement income and an increased ability to maintain purchasing power.

It is important to make informed decisions about your money. If this investment mumbo jumbo gets overwhelming, take a step back and think of it like a new career. It takes time to learn new skills. Remember, the right decisions will help you generate retirement income that will last-your own personal money machine.

If you would like to review these rules in light of the current market, feel free to contact our office for an appointment.