How to retire on a wounded portfolio

By Liz Pulliam Weston

Bob Clyatt was a dot-com entrepreneur who opted for early retirement at 42, confident that he and his family -- including a wife and two young children -- could live well on their substantial savings.

That confidence quickly turned to chagrin as the brutal bear market of 2000 and 2001 clobbered the family's investment portfolio. As Clyatt studied research on retirement planning and plugged different assumptions into retirement calculators, he realized his original plan was in real danger of failing.

Something would have to change, but he was determined not to give up his dream of retiring while he was still young enough to enjoy it. He reconsidered his withdrawal rate, revised his spending plans, reconsidered part-time work and wrote about the whole process in his book, "Work Less, Live More: The New Way to Retire Early."

His solutions, along with those of others who have faced similar challenges, show it's possible to retire even when the markets have knocked the stuffing out of your portfolio.

Here are some steps to consider:

Research your withdrawal options

"Sustainable" withdrawal rates are the chief goal of retirement planning, and most research shows that initial payouts need to be relatively small if you want your portfolio to stand up to bad markets and the erosion of inflation.

Many advisers use influential research by financial planner Bill Bengen to recommend starting at a 3% to 4% withdrawal rate, with subsequent amounts adjusted for inflation. If you take $40,000 from a $1 million portfolio in the first year, for example, and the inflation rate is 3.2%, your withdrawal the next year would be $41,280 ($40,000 increased by 3.2%).

This approach assures that your buying power remains intact over the years. But it may well require dipping into principal in bad market years. It also means you could run out of money in 30 years or so.

Clyatt's goal was somewhat different. Not only was his retirement expected to be unusually long -- he conceivably could spend two or even three times as many years in retirement as he did working -- but he wanted to leave a sizable inheritance to his children.

So he constructed a different withdrawal plan. He takes out about 4% of the total value of the family's portfolio most years. If the portfolio's value drops in a bad year, the family reduces its withdrawal to 95% of the amount taken out the year before. That way, Clyatt says, the family gets a "raise" in good years while only cutting back modestly in bad years.

With the help of market-research company Zunna.com, Clyatt stress-tested his concept using more than 70 years of historical returns. The portfolio not only survived, but more than 90% of the time the research showed he would be able to leave his kids an inheritance that was equal, in inflation-adjusted terms, to the original portfolio. The approach works with any size portfolio, Clyatt said -- not just supersized versions like his.

Of course, past results do not guarantee future returns, and it might be tough to keep cutting spending during an unusually prolonged downturn, particularly if you're starting with a modest amount. (A 5% cut in $100,000 leaves you enough to live, but a 5% cut in $20,000 may make life much more difficult.)

You may also decide a 4% withdrawal rate from your current savings won't generate enough cash to finance the life you want. If that's the case, you have more options.

Downsize early

If you live in one of the many superheated real estate markets around the country, you're probably sitting on quite a bit of home equity. You could consider putting that equity to work for you sooner rather than later.

Selling your home and downsizing to a smaller, less-expensive house could free up a chunk of money to bolster your retirement portfolio. You also could benefit from lower monthly expenses, since smaller homes tend to cost less to heat, cool, repair and maintain. Adding icing to the cake: up to $250,000 of your home-sale profits are tax-free ($500,000 for a married couple).

Even if you're not ready to downsize, you might be able to put some of your equity to work if you own other real estate. Several clients of now-retired financial planner Nancy Langdon Jones sold highly appreciated vacation homes and rental property to invest more money in stocks. (Jones herself sold her longtime home in Upland, Calif., to buy a smaller place in nearby Claremont as part of her retirement strategy.)

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