4 steps to a worry-free retirement

When your retirement goals seem harder to reach, it can be tempting to load up on stocks. There's a better way. If you look at all of your resources, it's easier to find the right balance between safety and risk.

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By Janice Revell, Money Magazine senior writer

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(Money Magazine) -- The stock market keeps taking a hammer to the conventional wisdom about retirement investing.

Conventional wisdom, circa autumn 2007 (Dow 14,000): You could be retired for 30 years or more. You need lots of stocks so that your money will grow enough to last that long.

Conventional wisdom, circa spring 2009 (Dow 7000): Holding too many stocks is a clear and present danger to your retirement plans. Save what's left of your portfolio and shift toward bonds. You can't afford to lose any more.

Conventional wisdom, circa autumn 2009 (Dow back up to 9500): Wisdom? Forget it. The market falls, it rises -- nobody knows why ... Can we talk about something else? Think Favre will make it through the season?

Even with the recent pop in stock prices, your 401(k) balance probably isn't where you want it to be. There are at least two natural responses to the market whipsaw. You can embrace the new momentum, going aggressively back into stocks in the hope of catching up again. Or just check out: With the market so volatile, your chance at a comfortable retirement may seem dicey no matter what you do. According to a recent Vanguard study, 401(k) participants as a group changed their allocations only slightly during the 2008 bear market.

Time to get constructive. The retirement you want may be more attainable than you think. Although you might have to save a bigger chunk of your income than you do right now, you also have resources beyond your 401(k), IRA, and Social Security.

Your home, your ability to work a few years longer, a pension if you have one (even if it's small) -- all these can have a big impact on your future income. Once you see how much they are worth, you'll be able to construct a realistic plan that doesn't force you to take huge gambles.

This story will show you what it takes to build up a sufficient nest egg with a conservative portfolio so that you can sleep at night even during volatile markets like this one. Your first task? Putting the long-term risks of stocks and bonds into perspective.

1. Know the risks

The stocks vs. bonds dilemma.

When you're saving for retirement, you have to strike a tricky balance. If you hold a lot in lower-risk bonds, your money won't grow very fast. You have to let your savings do all the heavy lifting, which can mean accepting a diminished standard of living if you didn't get a really early start.

Even then, you may not have eliminated all the risk. With most kinds of bonds, a spike in inflation can erode the real value of your returns, leaving you with less to live on than you had saved. (That's what happened to anyone who held Treasury bonds through the 1970s.) You can defend against rising prices with Treasury Inflation-Protected Securities, or TIPS. But their returns are modest -- the real yield on a 10-year bond is 1.8%.

Against that backdrop, "it's very tempting to rely on stock returns as the silver bullet for your retirement plans," says Boston University economics professor Laurence Kotlikoff. It's also dangerous, he adds. Yes, over the long haul stocks usually do a better job than bonds of growing your nest egg. Since 1926 stocks have returned average gains of 9.6% a year, while corporate bonds have returned only about 6%, according to Ibbotson Associates.

But as we've learned the hard way recently, those smooth averages hide a lot of wild swings over shorter periods. And if a deep downswing occurs when you are less than 10 or even 15 years from retirement, the consequences can be severe if you have a lot of stocks.

"At that point it's incredibly hard to increase your savings by enough to overcome the damage," says Alicia Munnell of the Center for Retirement Research.

In "You can't handle the truth about stocks," economist Zvi Bodie lays out his case for avoiding stocks entirely. But what if you're willing to live with some risk, yet still want to dial back your exposure?

What would you have to change if you decided to hold a portfolio split, say, 50/50 between stock and bonds? If you're 50 years old, that's cautious by many standards. A Vanguard target-date mutual fund designed for that age puts only 25% in bonds and the rest in stocks, working its way to 50/50 by age 65. Money's usual advice is about 40% in bonds at 50.

On many online retirement calculators, going to 50/50 in mid-career could point toward a higher savings rate than you may be accustomed to, easily in the 20% to 30% range. That shouldn't scare you off -- most of us have realized by now that the recent era of low savings was unsustainable. And amped-up saving may well beat the easy-seeming alternative of leaning on stocks.

2. Crunch the numbers

Why safety can improve your odds.

Since stocks tend to beat bonds over most long periods, any projection of how a hypothetical nest egg will grow has a peculiar effect: It will look -- at first glance -- as if stocks are the safer bet.

Let's consider a hypothetical 50-year-old earning $100,000 a year, with $300,000 saved in his 401(k). Let's assume he already ran a few numbers and decided he can live on about $1 million in retirement, which after inflation might work out to $1.65 million by 2024.

He definitely has a ways to go. Running those numbers through the Retirement Planner, it turns out that a savings rate of 15% -- plus a 3% 401(k) match from his employer -- will give him an 8-in-10 chance of hitting his number. That's if he has a portfolio of 70% stocks and just 30% bonds. Looks like a pretty good option.

But now let's say the volatility of the market has made him nervous and a bit disgusted, and he's thinking 50/50. In that case, the calculator shows that his odds fall to a little more than 6 in 10. In other words, the conservative portfolio puts him at serious risk of falling short. (Like most calculators, ours makes some simplifying assumptions about the range of future returns and should be used only as a ballpark guide.)

In order for our saver to improve his odds, he would have to save at least 22% of his salary, as you can see in the graphic ("Saving more helps aggressive investors," top right). This is starting to look like a no-brainer: It's a lot more fun to save 15% of income than 22%, and in both cases the odds of hitting $1.65 million are the same. So more stocks is the way to go, right?

Not so fast. The odds we've looked at so far express only the chances that the saver will pass that specific $1.65 million finish line. But with the 70/30 portfolio and a 15% savings rate, his potential downside if he doesn't make that mark is substantial. In one out of 10 cases, he falls short of his goal by $250,000 or more.

With the 50/50 split and 22% saved, the comparable shortfall is just $193,000. And in one out of 100 cases, the stock-heavy portfolio falls short by at least $865,000, vs. $657,000 for the balanced portfolio. That could easily be the difference between leaving a small inheritance and dying flat broke.

Suddenly, saving more in order to be a bit more conservative looks attractive. It increases your odds of avoiding a big loss. And of course saving more also ups your chances of success even if you stick with an aggressive allocation, as you can see in the chart ("Your goal is closer than it looks," above, right).

3. Worry less

What if you just can't save that much?

If your budget is tight today and you just can't find another dime to set aside -- well, you're not alone. But you should resist the urge to become really aggressive to make up for what you've lost. You probably have some other arrows in your quiver. Just one of the following can go a long way toward getting you to a comfortable retirement:

A PENSION, EVEN IF IT LOOKS SMALL. Talk of the demise of traditional pension plans is so widespread that even the people who have them may not appreciate how valuable they still are. Roughly two-thirds of employees at large companies and more than 90% of people who work in local, state, and federal governments still have access to one. If you are over 50, the chances that you're in a pension plan -- or were vested at a previous job -- are even higher.

Say that our hypothetical 50-year-old was entitled to an annual pension of $12,000 at age 65. That sounds paltry -- it's less than half his Social Security take -- but it means that instead of having to save 22% a year to go the 50/50 route, his minimum is closer to 17%. (See graphic "Your goal is closer than it looks," above, right).

YOUR HOUSE, IF YOU OWN IT. As lousy as the real estate market is today, your house should still add up to a very big asset if your retirement is a decade or more off. The simplest means of tapping equity in retirement is to move to a less expensive home and pocket the profit. A $100,000 gain could be converted into an annuity paying about $8,000 a year for life. Again, that would give you some leeway to tamp down your equity exposure today.

WORKING A BIT LONGER, EVEN IF IT'S PART-TIME. You could work a couple of extra years beyond 65. That helps even if you make less than you did most of your career. The key is to earn enough to cover living expenses without having to dip into your savings or start collecting Social Security. For each year that you delay Social Security, your eventual payment is boosted 8%.

And by the time you do retire for good, your nest egg will have grown larger, and you'll have fewer years over which you'll need to spread it. "The combined effect can have an incredibly powerful impact on your retirement lifestyle," says Steve Vernon, an actuary in Oxnard, Calif. If our 50-year-old worked until age 67 instead of 65, he'd need to save only about 12% of his pay each year.

ADJUSTING YOUR GOALS, WITHOUT REGRETS. If our hypothetical investor can't get to $1.65 million without taking a risk of ending up with half as much, it may make more sense to aim for $1.3 million instead. There's room to adjust: Many costs diminish as you age. Not only are your kids out of the house, but you may well have it paid off. Also, you are no longer setting aside part of your income for retirement savings.

And while the first 10 or so years of retirement may be occupied with travel and expensive hobbies, people tend to slow down later. "The need to accumulate more clothes, more cars, and more technology diminishes," says John Rekenthaler of Morningstar Associates.

Other than the pension, counting on any of these factors could nevertheless be a somewhat risky proposition -- your house may not be worth what you hope, you might not end up being healthy enough to work past 65, and you could be hit with big medical costs that increase your income needs.

But stocks are risky too. The idea here is that if you think you'll be able to tap one or two of these resources, you can make a conservative portfolio work even if you can afford only a moderate savings rate today. But by all means, save as much as you can.

4. Choose your tools

Where to put your money.

After you settle on your basic asset-allocation plan, there's more you can do with your specific investments to ensure a higher return with less risk.

EXPENSES AND TAXES: CONTROLLING WHAT YOU CAN. There are some easy ways to bolster your expected return without adding to your portfolio's volatility at all. First, focus on lower-cost mutual funds. A low-cost index fund charging 0.2% a year has a built-in performance edge over the average stock fund worth almost 1.2 percentage points of performance a year. That adds up quickly.

You can also shield your investment income against the very real possibility of higher future tax rates by putting at least some of your savings in a Roth IRA or Roth 401(k). With the Roth, you pay taxes on the money you put in but none when you take it out.

BONDS: KEEP YOUR "SAFE" ASSETS SAFE. Compared with stocks, bonds may be low-risk, but they're not no-risk. Bond prices can fall sharply when interest rates rise. Rates are low now, but there are plenty of concerns that they will rise significantly in coming years. "Stick with bonds that have maturities of no more than three years," says Chris Cordaro, an adviser in Morristown, N.J.

You also need to protect yourself against bond losses caused by defaults, so look at bond funds that concentrate primarily on high-quality issues, such as U.S. Treasuries, high-grade corporate bonds, and high-quality munis. A solid choice: FPA New Income (FPNIX), which is on the Money 70, our list of recommended mutual funds. A stake in TIPS, meanwhile, can protect you against an unexpected inflation spike. Two low-cost options for buying TIPS are Vanguard Inflation-Protected Securities (VIPSX) or going through the government directly at treasurydirect.gov.

STOCKS: WHERE TO GET LESS RISK. Stock investing is generally bumpier if you buy equities that are expensive relative to their earnings and assets. "You don't get rewarded for taking risk; you get rewarded for buying cheap assets," says Jeremy Grantham, co-founder of the investment firm GMO.

So if you are looking beyond low-cost index funds, consider managers with a value bent. Two solid Money 70 funds that hunt for blue-chip values: Jensen (JENSX) and FMI Large Cap (FMIHX). You can also focus on stocks that pay out dividends, which tend to be far less volatile than those that don't. Consider the iShares Dow Jones Select Dividend Index ETF (DVY) for that. These funds, like all stock investments, will still give you plenty of ups and downs. But with a well-balanced retirement portfolio, you won't feel so whipsawed.

To see if your finances are in peak shape, take our retirement readiness quiz.  To top of page

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