Taking Care of Mom and Dad: The 4 to 5 Percent Approach

If you're wondering how much your parents should be withdrawing from their nest egg on a monthly basis to cover expenses, it's good to know about the 4 to 5 percent rule. Although the actual withdrawal amounts will vary with age and health, under this approach your parents should target spending no more than 4 to 5 percent of their accumulated assets. So, if they have a nest egg of about $500,000, invested in stocks, bonds and cash equivalents, they can safely withdraw about $2,000 a month, or $24,000 a year, regardless of the returns each year. This reduces your parents' risk of losing it all in a down market. Because they are taking out a fixed percentage, when the market rises, they can take out more each month; if it hits a rocky period, they automatically take out less.

Most investment experts will tell your parents to divide their nest eggs between equities and fixed-income securities. They should be focusing on the total return of their portfolio instead of just income. During stable markets, stocks can be income producers because they can keep up with inflation.

With this strategy, your parents build a balanced portfolio of typically 40 percent stocks and 60 percent bonds and settle on a 4 or 5 percent withdrawal.

If your parents adopted a 5 percent withdrawal rate, retired with $400,000 and their investments grew 5 percent a year, they would pull out $20,000 in the first year of retirement, $21,000 in the second year, $22,050 in year three and so on. (The withdrawals would increase or decrease each year, in proportion to their investments.)

This approach usually combines dividend and interest payments with asset sales to maintain the steady withdrawals. Not surprisingly, retirees like the idea of getting increasing income every year. But there's a hitch: If your parents slavishly follow the strategy, they could rapidly deplete their nest egg if markets are unkind.

Baltimore's T. Rowe Price Associates calculates that, with a balanced portfolio and a 5 percent withdrawal rate, there is a 42 percent chance they would run out of money over a 30-year retirement.