How to safely invest your retirement cash

(Money Magazine) -- Question: I recently had to take early retirement at age 57 because of back problems. I'm now looking for a safe place to invest my retirement money where I'll have no risk losing it. Any suggestions? -- Donald H., Morris, Alabama

Answer: If the threat of losing principal were the only financial risk you had to protect yourself against in retirement, then finding a safe haven for your money would be pretty simple. You could plow your entire nest egg into Treasury bills or spread it among FDIC-insured savings accounts and CDs (taking care to stay within the FDIC coverage limits).

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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).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

But while doing this would insure that you would never lose a cent of your money, it would also insure that your retirement stash earned a pretty measly return. According to the Treasury Department's Daily Treasury Bill Rates bulletin, short-term T-bills (those with maturities of less than one year) have recently been yielding under 0.20%, while money-market funds specializing in T-bills and other government securities yield even less. Bank CDs andsavings accounts haven't been paying much more, on average about 1% or less.

Even if you manage to do a little better by careful shopping around you would still have to grapple with the same underlying issue: The need to sustain yourself during a long retirement. That's a challenge virtually all retirees face. But since you're leaving the workforce early, it's an even bigger issue for you. At age 57, you're likely to live another 30 to 40 years. So unless you have a very large pot of savings to draw from -- or the amount of annual income you need to pull from savings to live comfortably is exceedingly small -- a very low rate of return on your savings increases the chance that you may run through your nest egg at some point during retirement.

But don't just take my word for it. Go to T. Rowe Price's Retirement Income Calculator and plug in your financial info -- the amount you have saved, projected Social Security benefit, how much you anticipate having to pull from savings each year -- and then run a scenario assuming you're 100% invested in cash and cash equivalents.

I think you'll be surprised at how quickly you can go through your savings when you're huddled down in the most secure investments. All of which is to say that while security of principal is certainly a big concern, it's not your only one.

If you want to have a decent shot at your retirement savings lasting as long as you do, you also want to invest in a way that has at least some potential for long-term growth.

So how do you balance your need for security of principal with the need to make your money last throughout retirement?

There's no one correct solution. What's right will depend on your particular circumstances -- how much savings you have, how much income you'll need to pull from it, how jittery you get you're your account balances bounce around and how much wiggle room you have for cutting back on your expenditures should your nest egg's value sink.

But here's a way for you to arrive at a tradeoff between short-term and long-term security that works for you. The first thing you want to do is make sure you have a sufficient amount of cash on hand to fund day-to-day living expenses for a reasonable amount of time. For most retirees, that probably translates to 12 to 18 months' worth of living expenses, enough so that you're not forced to dip into retirement investments during a market trough.

You may very well want to be at the far end of that range or even consider having upwards of two years' worth of cash. Why? Well, most early retirees likely have the option of returning to work occasionally or taking on a part-time job to give their nest egg a chance to rebound if it's balance has been depleted by the combination of market setbacks and withdrawals.

To the extent your back problems limit this option, you may want to compensate by having a bigger cash cushion. The rest of your savings you want to keep in a diversified portfolio of stock and bond funds. Again, there's no single correct mix. Typically, though, someone just entering retirement might have 50% or so of his or her portfolio in stocks and the rest in bonds.

Over the years, that person would gradually scale back that stock stake, until it reached, say, 20% to 25% stocks in his or her 70s or 80s. That said, more risk-averse retirees might prefer starting retirement with more like 30% to 40% in stocks. A more conservative mix provides greater short-term security, but less growth potential for maintaining purchasing power in the face of inflation.

To see how different blends of stocks, bonds and cash affect the chances of your money lasting throughout retirement, you can check the Retirement Income Calculator I mentioned earlier.

By the way, while you're mulling how to invest your savings, you'll also want to consider some non-investing issues. Since you won't qualify for Medicare until 65, you'll want to be sure you have some sort of health insurance in the meantime (especially given that bum back of yours).

There's also the question of where your retirement savings are. If you still have money in a 401(k), you may want to leave at least some of it there for the next couple of years. The reason is that if you're at least 55 when you leave your company, you qualify for an exception to the 10% penalty on withdrawals from 401(k) accounts prior to age 59 ½. So by keeping your money in your 401(k), you can pull it out and pay only income tax on the taxable portion of the withdrawal.

If you roll your money into an IRA account, by contrast, you would owe tax plus a 10% penalty on withdrawals before age 59 ½. There are exceptions to the pre-59 ½ penalty for IRA accounts too, but taking advantage of them could be cumbersome. (For example, to qualify for the exception for people with a disability, according to the IRS, you must "furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.")

If you have savings in taxable accounts, you can avoid the whole 10% penalty problem by taking withdrawals from those accounts. As far as investing your savings goes, however, I'd think twice before plowing it all into investments that offer the maximum stability of principal. That approach may make you feel secure now, but it could leave you vulnerable down the road.