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» Investment Planning
» Estate Planning
» Retirement Planning
» How to Live Off Your Nest Egg
» Making Your money Last Through Retirement

How to Live Off Your Nest Egg

Once you’ve decided to call your own shots in life, investing is a whole different game. Here’s how to find the income you’ll need without risking everything.

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. 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.

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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. Especially if you’re retiring young, you’ll want to do more traveling and upgrade your golf clubs.

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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. 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.

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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. 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.

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.

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.

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. Some financial advisors suggest holding seven to 10 years’ expenses in this pot. During the 1970s bear market, 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.

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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 Treasury’s 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.

Here are a number of fixed-income alternatives:

Treasury’s: Yields on Treasury’s can be so meager that they only really make sense if you’re an extremely risk-averse investor. Backed by the U.S. government, Treasury’s are about as safe as they get -- but you sacrifice yield.

Corporate bonds: Corporate bonds can be hard to analyze, and the costs of buying them are often hidden. The issuer often has the right to call a bond, or to redeem it before maturity. But you do get more yield. Stick with investment-grade corporate, and stay away from bonds with maturities of 12 or more years. And unless you have $200,000 or more to put into individual bonds, the cheapest way to invest is via a low-cost mutual fund, preferably an intermediate-term fund. These generate more income than short-term funds.

If you’re willing to take on more risk, check out high-yield bond funds. They invest in lower-quality corporate bonds and can produce high yields when market conditions are ripe. With the economy improving and interest rates poised to go higher, this is an area that’s going to perform well. This is not the place to put a lot of your fixed-income money. The risk level is similar to buying stocks. But if you want some spice, this is a good place to look.

Real-estate Investment Trusts: REITs have generated yields in recent years that most people only dreamed about. REITs invest directly in real estate such as office buildings, apartments and shopping malls, or they carry mortgages on these properties. They pay no income taxes so long as 90% of net income is passed to investors as dividends. The best way to buy REITs now is through exchange-traded funds -- low-cost buckets of securities created by investment firms. Another good bet is a low-cost traditional mutual fund.

Convertible bonds: Convertibles are essentially bonds that can be converted into common stock. They follow the tail of the stock market, while providing downside protection. A typical convertible will get 60% to 80% of the upside potential of the stock market, while giving you less than half the risk.

Dividend-paying stocks: Dividend yields are on the rise again because of tax breaks.

Treasury Inflation-Protected Securities: TIPs, as they're called, are basically Treasury’s with a bonus: Your principal is tied to inflation. While inflation is still low, it has been inching up as the economy perks up. Your return on a TIP comes in two parts: a fluctuating return that’s based on the inflation rate and paid out at maturity, plus the current yield, a fixed return paid out annually. The downside: You pay taxes on any gains on your principal each year, though you won’t get the money until maturity. As a result, financial planners typically recommend holding TIPs in tax-favored accounts such as Individual Retirement Accounts or Keogh plans. How to get in? Via low-cost mutual funds for the convenience.

Municipal bonds: If you’re in a high tax bracket, don’t overlook munis, which are exempt from federal taxes. If you buy one issued by your state, it will be exempt from state taxes, too. The federal tax savings alone can make munis look a lot more attractive than other bonds. But buying individual munis isn’t always easy. They’re generally sold in lots of $25,000. So look to mutual funds here. They come with relateively low expense ratios, compared to other muni funds.

Agency bonds: These bonds, issued by government agencies such as Fannie Mae and Freddie Mac, are about as safe as you can get next to Treasury’s and generally offer higher yields. Unless you have a large amount to invest -- $1 million or more -- stick with the lowest-cost mutual funds.

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The easy alternative
If you’re overwhelmed by the task of creating your own portfolio, don’t sweat it. An easy alternative is a fund that gives you broad exposure to various bonds.
A favorite broad bond fund is Vanguard Total Bond Market Index (VBMFX). It’s a one-step solution to your fixed-income portfolio. Another fund that’s top-rated by Morningstar: Dreyfus Intermediate-Term Income (DRITX), which holds a mix of Treasury’s, agency bonds, investment grade and high-yield corporates.

Indeed, as long as you keep a lid on expenses, it can pay to let the professional financial planners run your portfolio. Let them decide what to buy, what to overweight, what to sell. You, meanwhile, will have more time to enjoy that new financial freedom.

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