Fixing a stock-heavy retirement account

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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NEW YORK (Money) -- Question: I'm 55 years old and have my entire retirement savings plan at work invested in a total stock market index fund. I'm worried, though, that my account is too heavily skewed toward equities given my age. Any suggestions for how I might take a more balanced approach? --Ray K., Oakland, California

Answer: You're right to be concerned about having your entire retirement portfolio riding on stocks at your age. The problem with relying too heavily on equities as you near retirement is that your nest egg can get whacked so hard when the stock market dives that you may not be able to get back to the balance you need to live comfortably by the time you plan to retire.

Indeed, if you were invested this way in 2008, your account balance would have dropped about 37% for the year (excluding the effect of any new contributions you made). And you would have suffered another investment loss of almost 11% for the first quarter of this year.

Granted, your balance would have rebounded sharply as stock prices rallied from the market's early March low. But even that nice boost wouldn't have brought you back anywhere close to even (again, not counting new contributions), since stock prices today are still off a third or so from their peak values in October, 2007.

The point is that once you're in the home stretch to retirement, you don't want to expose your retirement account to wild swings in value. Otherwise, you could end up in the position that many would-be retirees found themselves in after the market's crash -- i.e., having to decide whether to retire on schedule but ratchet down their standard of living, or, postpone retirement several years until their account has recovered enough to provide a reasonable lifestyle and decent level of financial security.

So, yes, I do have a suggestion for how you can take a more balanced approach: diversify your retirement savings account so that you have some money invested in bonds as well as stocks.

Despite all the absurd talk you hear about the death of diversification, the fact is that a broadly diversified bond portfolio can act as a shock absorber of sorts, cushioning the blow your retirement account suffers when the stock market takes a dive.

Last year, for example, while your total stock market index fund was on its way to a loss of about 37%, a total bond market index fund would have returned 5%. That may not seem like a lot, but remember: every dollar invested in the bond fund not only gained a modest return, it also avoided a big loss.

The real question for you, it seems to me, isn't whether to move some of your money from stocks to bonds, but how much? In other words, what's the right stocks-bonds mix for someone your age?

There's no one-size-fits-all answer because so much depends on your individual situation, including such factors as how large your retirement account is, how much money you need to pull from it, what other resources you can tap for retirement income and how flexible you are about postponing retirement or working during retirement.

That said, I think that a decent starting point for people in their mid-50s is 60% to 70% stocks with the rest in bonds. If you could easily afford to cut back on withdrawals from your portfolio in the event of a market setback -- or if your portfolio is so large that you don't have to worry about running through it in your lifetime -- then you might prefer the upper end of that range in stocks. The same might apply if you've got a generous traditional pension that, combined with Social Security, will take care of most of your income needs.

If, on the other hand, you really need those draws from your retirement savings to maintain your standard of living, then you might want to stay at the lower end of that range, or even dial it back a bit.

The key, though, is to not to overdo it in either direction. Invest too heavily in equities in an attempt to recoup last year's losses and you could find yourself in trouble if the market takes another dive just before or after you retire. Play it too safe because you're skittish after getting burned last year, and you might not be able to maintain your lifestyle in the face of inflation over a long retirement.

Whatever mix you decide on, you'll want to gradually shift more into bonds (and, eventually, cash equivalents) as you age. The idea, again, is to reduce the fluctuations in the value of your portfolio as you near and then enter retirement.

You can see how different mixes of stocks and bonds might affect your retirement prospects by revving up such online tools as Morningstar's Asset Allocator, T. Rowe Price's Retirement Income Calculator and Fidelity's myPlan Retirement Quick Check.

But when you check out such tools, remember: They can give you a sense of how things might turn out based on past history and reasonable assumptions about the future, but they're not crystal balls. Whatever strategy you come away with, be sure you would be okay living with the consequences if things turn out worse than expected.

So spend a little time with the tools I mentioned -- or, barring that, sit down with an adviser -- and focus on creating a blend of stocks and bonds that can provide a reasonable balance of growth and protection. Because when it comes to retirement investing, as with much else in life, balance is a good thing.