How to drop out and live off your nest egg

By Karen Hube

You may be psychologically ready to walk away from the rat race, but are you financially ready? Figuring out whether you have enough saved is just half the battle. The other half is creating an investment plan that will generate income without drying up your stash.

If you're in your 40s or 50s, these are huge hurdles. It's hard to predict how much income you'll need over decades of retirement, and your interests and needs are bound to fluctuate over the years.

When it comes to investing, you can't simply rely on the traditional advice for retirees, which is to put most of your savings into corporate bonds and dividend-paying stocks -- and then live off the income. "That's far too conservative for someone younger," says Matt McGrath, a financial adviser in Coral Cables, Fla. "That kind of portfolio would hurt your total return over time, and you would risk using up your savings too quickly."

Worst case: You retire too early -- and with too little planning. In a few years, you end up scouring the job listings and circulating your resume. So much for getting out of the rat race.

Make sure you have enough in savings

To figure out if you've saved enough, there are a number of helpful Web tools. Whatever the tool, be sure you understand -- and agree with -- its assumptions. Some calculators assume that you will need income only for 25 years. If you retire in your early 50s, you will need your money to last much longer.

If you'd rather consult an expert, you can hire financial institutions or planners to crunch numbers for you. Find one using the latest income-planning software that analyzes the probability of your money lasting based on assumptions about your spending and portfolio growth.

Whatever resources you use, don't make unrealistic assumptions about the returns your savings and investments will generate -- or about how much you'll spend.

"You have to be prepared for the absolute worst -- deep, long recessions -- and assume you'll spend at least as much as you do now," says Malcolm Makin, a financial adviser in Westerly, R.I. "Especially if you're retiring young, you'll want to do more traveling and upgrade your golf clubs."

Set up a portfolio for growth and income

Once you've got enough squirreled away, you need to establish a reliable system that allows you to invest in stocks for long-term growth, while holding enough in fixed income to give you a reliable source of income for years to come.

This is a tricky balance to strike. "If you put too much in fixed income, you risk running out of money because you won't get the growth you need," says Lynn Ballou, an investment adviser in Lafayette, Calif. "If you put too much in stocks, but you don't get the return you're hoping for, you'll be in big trouble.

Just imagine if you had retired in 1999 with the bulk of your portfolio in stocks. During the crash that followed, you'd have been selling assets while they were under water," Ballou says.

The three-pot retirement income engine

Many planners recommend organizing your portfolio into three pots:

• One for cash expenses expected in the next year

• One for fixed income investments to feed the first pot

• The last for stocks that will provide growth to fund the first two pots

The idea is that as cash reserves decline, you can replenish them with overflow from the other two pots.

When the stock market is down, you may want to do so with some interest and dividends, McGrath says. When the market is strong, you'll probably have a greater percentage of stocks than you intended. "So when you sell off stocks to rebalance, direct the proceeds into your cash pool," McGrath says.

You can also generate a constant flow of income if you diversify your fixed-income pot with investments of varying maturities. Stay away from maturities of 12 years or more. "You get much more volatility and not much more return," says financial planner Michael Chasnoff of Cincinnati.

When you're deciding how much money to put in each pot, think carefully about your needs and your risk tolerance. This can affect how you save for and how much cash you make available every year. "This is one of your most critical decisions -- it can make or break your retirement," Ballou says.

If your cash pot holds about a year's worth of expenses in a money-market fund, your fixed-income pot should harbor at least four years' expenses. Ballou suggests holding seven to 10 years' expenses in this pot. During the 1970s bear market, she says, it would have taken about that much to get through the rough years without having to sell stocks at depressed prices.

The rest of your retirement savings can go into stocks or stock funds. If you're a seasoned investor, you're probably already comfortable setting up a diversified portfolio. Divide your money between large and small issues, growth and value, domestic and international.

If you're a new investor, lots of advice is available. On this site, the Start Investing decision center is a good place to start.

Get the most from fixed investments

Deciding where to put your fixed-income money can be a challenge. Even many experienced investors aren't faced with this challenge until they retire.

The traditional approach is to diversify your fixed-income portfolio with Treasurys and investment-grade corporate bonds of differing maturities. But someone with a much longer investment horizon may want to be more discerning and creative to eke out more return, Chasnoff says.

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