Clients can do every-thing right — save early and often, and invest wisely — and still wind up struggling in retirement if they start drawing down savings too aggressively or get hit with an ill-timed market plunge. When it comes time for clients to deplete their nest eggs, they need to be as disciplined as they were when they were building them.

Saving for retirement is a process that is wracked with uncertainty. There is no telling how a particular portfolio will perform. Over the long term, variables such as inflation and interest rates are unknowable.

And, as clients approach retirement, they have to face an additional unpleasant yet critical uncertainty: death, and whether it comes after they run out of money.

When it comes to calculating whether clients have saved enough to retire, the problem is that lifespan is inherently unknowable. A portfolio that is large enough to provide 10 years of comfortable retirement income could be insufficient if retirement happens to last 30 years.

This overriding uncertainty also afflicts the decision of just how much clients should plan on withdrawing from their savings once they retire. If clients knew their savings had to last only 10 years or less, they could comfortably spend 10% a year (assuming an effective return of zero on the portfolio during those years). But, should your clients live longer than 10 years, having spent 10% a year, they will end up destitute.

A fair amount of research has gone into portfolio withdrawal scenarios. Moshe Milevsky, finance professor at York University, has done a good deal of work on the issue, and he suggests that the average 65-year-old retiree should plan on withdrawing no more than 5% of his or her initial savings, adjusted each year for inflation. People who expect to die young or who are willing to assume the risk of running out of money could push it to 6%, he says.

Indeed, Milevsky’s research finds that a 65-year-old retiree faces a 19% chance of exhausting his or her financial resources before death if the retiree spends 5% of an equities-based portfolio (assuming a real return of 7% with 20% volatility). That risk rises to more than 26% if the retiree spends 6% a year, and drops to about 12% if only 4% is withdrawn.

Dan Hallett, president of Windsor, Ont.-based mutual fund research company Dan Hallett & Associates Inc. , allows that numbers such as 4% or 5% can be used as a general guide. But, ultimately, the individual circumstances and the real-life portfolio performance — return and volatility — should also dictate behaviour.

“For instance, when it is said that the safe withdrawal rate is 4%-5%, that’s just the first year’s withdrawal as a percentage of the starting portfolio value. That first year dollar value would then be indexed to maintain the standard of living,” Hallett says. “In such a scenario, the actual withdrawal percentage would vary widely because of portfolio volatility. But the idea is that you set the bar lower at first so that you leave room for growth of that cash flow and some margin of safety to withstand portfolio volatility.”

Indeed, Milevsky’s results are very sensitive to both expected return and market volatility. For example, according to his results, if a portfolio generates only a 5% return with 20% volatility, a 65-year-old spending 4% of the portfolio each year faces a 22% chance of outliving his or her money. The retiree would have to keep spending down to just 2% a year to lower the probability of exhausting the savings to less than 10%.

Similarly, if the portfolio returns 5% and volatility is only 10%, the same 65-year-old client would have just a 7% chance of outliving his or her money if he or she spends 4% each year, according to Milevsky’s research.

Volatility is a much bigger concern for a portfolio that is being depleted as the investor cashes in savings to fund retirement than it would be for an investor who is still living off employment income and saving for retirement. As Hallett points out, even with prudent planning: “The portfolio’s returns in the first five to seven years can make or break even the longest-term plan.”

Further research by Milevsky has shown that the timing of returns is very important to retirees’ portfolios. He calls the five years immediately before retirement and the 10 years after the start of retirement the “retirement risk zone.” During this period, weak returns can severely curtail a portfolio’s lifespan.

@page_break@The reason is that negative returns hurt much more when a portfolio is also being depleted by the investor’s consumption. During the saving years, a 10% drop in a portfolio’s value can easily be made up by a rally of at least 11% the next year.

By contrast, in a portfolio in which a 10% drop in market value is accompanied by 5% in consumption, the client needs a rebound of about 18% the next year to get back to neutral. Those negative returns hurt somewhat less toward the end of a portfolio’s life, but can be devastating when they occur at the beginning.

Given that the timing of returns is obviously beyond investors’ control, they can expect to preserve portfolio longevity only by maximizing return and limiting volatility. Diversification is a well-established tactic for maximizing return for a given level of volatility. The theory is that overall portfolio return will be increased if an investor holds a variety of assets whose returns are not closely correlated. When one asset’s return is down, another asset will probably be taking up the slack.

Portfolios can be diversified among asset classes (for example, stocks, bonds and cash), by geography (including assets from different parts of the world whose returns don’t move in lockstep) and by sector (when resources stocks are doing poorly, for instance, financials may be doing well).

Asset mix is also a key consideration. While equity returns tend to be more volatile than those for fixed-income assets, they also tend to be larger in the long run. Portfolios that are more heavily weighted with stocks will produce larger overall returns in the long run; these sorts of portfolios can, however, face significant short-term volatility. And given the importance of volatility in portfolio durability, that may not be something that many investors will be willing to endure.

Apart from diversification and asset mix decisions, investors who are concerned about their portfolios’ durability may have to consider minimizing depletion should returns be disappointing in the early years of retirement.

That could mean cutting back on spending — putting off plans for that trip around the world — or seeking out alternative sources of income (other than from the portfolio).

The reality is that there are no hard and fast rules for investors to follow that will tell them how much they can draw down their portfolios during retirement. The answer depends not only on the size of their returns, but also their timing.

If they happen to hit retirement in the throes of a prolonged bull market that delivers 20% annual returns for those first few years, they can safely withdraw a fair-sized chunk of that initial portfolio.

But if they hit retirement just as the markets are slumping, they may have to reconsider whether it is safe to retire at all. IE