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Publication: Investor's Notebook
INCOME LIMITS FROM YOUR NEST EGG

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        Investor's Insight - January 9, 2007           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"

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INCOME LIMITS FROM YOUR NEST EGG
by Scott Burns

Q: It is recommended that retirees withdraw no more than 
4 percent a year from their retirement nest egg. Is this 
in addition to any income that is generated from their 
funds? Bonds and CDs pay more than 4 percent. And some 
higher-dividend stocks pay more than 4 percent. If we are 
generating more than 4 percent a year in income and we 
only withdraw a total of 4 percent, wouldn't we be build-
ing the principal? What am I missing? -- B.N., by e-mail

A: The 4 percent figure is based on the value of the port-
folio. The dividend and interest income that your port-
folio generates is considered part of the total return. 
The remainder of the return comes from capital gains or 
losses.

Another way to look at this is that your portfolio needs 
a total return that is equal to your withdrawal rate plus 
the inflation rate -- roughly 7 percent -- if it is to 
generate a growing income.

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Many people forget this important part of the portfolio 
survival studies -- that the 4 percent figure is your 
initial withdrawal rate. It is assumed that your with-
drawal increases at the rate of inflation every year 
after that. Otherwise, you will be losing purchasing 
power every year. 

For example, if your portfolio is $500,000, you start 
with a $20,000 withdrawal in the first year. If the rate 
of inflation is 3 percent, your withdrawal in the second 
year is $20,600, $21,218 in the third, $21,854 in the 
fourth, $$22,510 in the fifth, and so on. Roll that out 
for a decade or more, and the withdrawals get hefty.

It would be easy to get a 4 percent current income yield 
from bonds and CDs. It's not so easy to get the 7 percent 
total return required to keep up with inflation. Settle 
for a 4 percent total return and, eventually, you'll be 
spending your principal. Similarly, while there are some 
stocks that pay over 4 percent in dividends, many stocks
pay no dividend. 
 
The vast majority of stocks pay far less than 4 percent. 
In the current market, for instance, a traditional manag-
ed balanced portfolio -- 60 percent stocks, 40 percent 
bonds -- produces an average yield of only 2 percent, 
according to Morningstar data. The Vanguard Balanced In-
dex fund, in the same period, produced a yield of only 
2.9 percent. Either way, it's difficult to get a rising 
4 percent annual income. 

Q: I recently bought several exchange-traded funds (ETFs) 
-- this after having owned mutual funds for some time.

Mutual funds are valued at the end of the day at the net 
asset value of the equities owned by the fund. Is the 
value an ETF is listed at and trades at related to the 
value of the equities held by the fund? Or is it a value 
that buyers and sellers agree to make a trade of the fund 
shares at that is otherwise independent of the value of 
the equities held by the fund? -- B.J., by e-mail

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A: In a mutual fund, the investment company issues or re-
deems shares based on the net asset value per share of the 
underlying portfolio at the end of the day. 

An exchange-traded fund is different. Your shares trade at 
the market price throughout the day, independent of the 
underlying net asset value of the fund. This may sound 
risky, but the majority of ETFs trade within a one-quarter 
of 1 percent premium or discount to their underlying net 
asset value, most of the time.

This is quite different from closed-end funds whose shares 
also trade at market prices, not net asset value. Closed-
end funds often sell at substantial premiums or discounts 
to the net asset value of the underlying portfolio.

Exchange-traded funds have avoided this problem by having 
large trading entities create or dissolve relatively large 
units of the fund at any time. These traders will create 
or dissolve these large units whenever there is a profit-
able gap between the market price and the underlying net 
asset value of the shares. In Wall Street language, they 
arbitrage away the spread between market price and net 
asset value per share.

You can discuss this issue or any other topic in the new 
Investor's Insight forum. Check it out here...

 
Investor's Insight Forum

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).

COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE

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