(MONEY Magazine) – You couldn't have seen it coming. Not like this anyway. This year the oldest of the baby boomers will turn 61, just inches away from being eligible to collect their first Social Security check. Roughly 60 million more are in their late forties or fifties, the season of life when 401(k) statements suddenly become really, really interesting. That much you knew would happen, even if it was hard to imagine when you were sitting in your dorm room decoding Jefferson Airplane lyrics. In fact, despite the generation's forever-young stereotype, many boomers started planning for retirement some time ago. According to the Congressional Budget Office, the typical boomer has accumulated about as much wealth relative to his income as the previous generation had by the same age. (Good thing, because he's less likely to have a pension.)

But whether you were a yippie or a yuppie or maybe both, this part must have surprised you: Your adult life coincided with the one of the greatest investment booms in history. Over the past 30 years, large-company stocks returned 12.5% a year compounded, enough in theory to turn $1,000 into $34,000. In real life it wasn't so simple— besides taxes and expenses, most of us eat away returns trying to outsmart the market—but that's a heck of a wind to have at your back. On top of that, many boomers are also sitting, perhaps a bit nervously now, on some seriously appreciated real estate.

Now remember what the world looked like in the mid-1970s, when you were just getting started. Vietnam and Watergate were fresh national wounds. The Arab oil embargo had pushed the economy into a deep recession. The stock market was still recovering from a major crash—the Dow had tumbled 45% from peak to trough—and annual inflation topped double digits. A cover story in this magazine offered advice on coping with the soaring price of meat, milk and margarine. Seriously.

America's economy—and even more so its markets—has traveled a long way in three decades. That's worth meditating on right now because you may very well have another three decades (or more) to make your money last. And history needn't surprise only on the upside. As you plan for the years ahead, you'll need to make some assumptions, and the first thing you should assume is that your investments will grow more slowly than recent performance might suggest.

That's no reason to become discouraged—there's a lot you can do to ensure that you'll thrive even when the markets disappoint. In this 35-page special report dedicated to boomers, you'll find plenty of practical strategies to make the second act of your life as rewarding as the first. But first we'll answer the tough questions about where the money you'll need is going to come from.

Q How much can I expect to earn from stocks and funds?

A Chris Cordaro of RegentAtlantic Capital, a wealth-management firm in New Jersey, assumes a large-cap stock return of just about 8% before inflation. That's a lot less than 12.5% or even the roughly 10% that large-caps have produced since 1925, according to Ibbotson Associates. Cordaro's prediction echoes the view of a number of economists and market watchers that stock returns should fall. Why? Cordaro says that the big gains of the past were "the result of a repricing that you can't figure will keep happening." Investors, the argument goes, placed too low a value on stocks in the past. But a lot happened in the 20th century to make stocks more attractive. The U.S. emerged as an economic superpower, and the economy became more predictable, especially as inflation and interest rates moderated. With tools like mutual funds and 401(k)s, it's easier to buy stocks. And you've heard many times from your broker, the press, and books like Jeremy Siegel's Stocks for the Long Run that stocks have been consistent winners provided you hold them long enough. Roughly half of Americans own stocks, up from 32% in 1989. With high demand making stocks more expensive, it's reasonable to assume they have less room to rise; even the bullish Siegel expects after-inflation returns to be about a point lower than the long-run record.

Rob Arnott, a money manager and former editor of the Financial Analysts Journal, is even more pessimistic. "My message to boomers is simple," he says. "Don't count on the market to bail you out." He's calling for a 6% long-run equity return (before inflation). Arnott has an elaborate set of calculations to back up this call, but you really needn't agonize over whether Arnott or Siegel has the right number. What matters for your planning purposes is what could happen, and history shows that stocks can lose money, after inflation, for long periods. They declined at a rate of 0.4% from 1966 to 1981, Siegel notes. A bad stretch isn't such a problem when you're 30. But it can be a big problem after you've retired, especially if you were counting on 10%. So don't count on it.

Q I've read that we're a demographic time bomb. Will we crash the market just when I retire?

A From an economic perspective, boomers have three key traits: There are a lot of you. You didn't choose to have big families. And you are going to live a mighty long time. What all that adds up to is that by 2030 there will be barely three Americans of working age for every person over 65, compared with a ratio of five to one today. That's going to be a significant challenge to Social Security (see the box on page 74). It might also be a problem for stocks. To finance their retirement, folks over 65 will have to sell assets, but there will be relatively fewer young Americans to buy them.

This shift could certainly be another long-term drag on your returns. Economist James Poterba of the Massachusetts Institute of Technology guesses that it might cost investors an average of a quarter to half a percentage point per year. But don't waste your time listening to any market guru who promises that demographic trend lines can tell you when to hop out of stocks to miss the boomer-driven crash. There may never be one, Poterba says. The so-called age wave is a widely known and easily tracked statistical event, and the market has a way of calculating information into prices long before any zero hour arrives.

Several forces could blunt the impact of boomer aging. Siegel, for example, has argued that a rising middle class in India and China will seek the safety of U.S. equities. And boomers surely aren't going to try to sell all at once. Some will hardly sell at all. A big chunk of this country's assets are in the hands of the richest investors. "Most wealthy people save a high percentage of income," says Roger Ibbotson, founder of Ibbotson Associates and professor at Yale School of Management. "They aren't really digging into their savings when they retire."

Q I made 20% in a foreign fund last year. Can't I juice up my returns by going overseas?

A Because other countries' markets don't always move in sync with ours, holding a stake in a foreign fund can smooth out your performance and maybe even kick up your returns. Over the past five years, in fact, foreign stock funds have averaged a 15% annual gain, compared with just 7% for U.S. large-cap funds, a record that has drawn a flood of new investors. But you shouldn't expect that kind of extreme outperformance to continue. In a globalized world, a multinational company based in Paris doesn't really face different economic realities from a competitor in Chicago. And Europeans and the Japanese are facing an even bigger demographic crunch than we are—they're not having enough babies to replace their current population.

Emerging markets—that is, less-developed economies including China, Latin America and Russia—seem to offer potential for bigger gains. But that's because they are also a bigger risk. On average, diversified emerging markets funds rose a stunning 25% annualized over the past five years, but they also lost half of their value during one bad 12-month run in the late 1990s. And the long-term record of emerging markets isn't as impressive as you might think, says Yale finance professor Will Goetzmann, a leading expert on past market returns. "Despite their risk, emerging markets historically really haven't done that dramatically better over the long term," he says. And although the fall of the Berlin Wall and the economic emergence of China would seem to herald a new era of opportunity, Goetzmann cautions that some markets can disappear as quickly as they "emerged." Most investors should keep their emerging markets bet small, perhaps by simply buying a diversified foreign fund that dabbles in those countries. More adventurous types might think about putting 5% of assets in a dedicated emerging markets fund.

Q What about commodities? I hear they're the next big thing.

A Wall Street's been pushing them pretty hard lately. It seems like every week a new mutual fund or ETF is launched to track one commodity or another. But before you climb into the trading pit, remember that your odds of consistently outsmarting the market's bet on the value of a bushel of wheat or a barrel of oil aren't any better than your chance of guessing what's next for Google. The best case for buying commodities is for diversification. New research shows that a broad index of commodities futures can offer solid long-term returns, while in the short-term they can often rise as stocks fall (and vice versa, of course), lowering your overall volatility. If that's attractive to you, you can buy an exchange-traded investment like iPath Dow Jones-AIG Commodity Index Total Return (ticker symbol: DJP), a MONEY 70 pick that tracks the return of a commodity index at a low cost.

Still, these new and complex investments are strictly for the advanced investor. Even then, it's possible that commodity returns will erode now that the big money on Wall Street has piled in. "People become enamored of assets that are good diversifiers only after they've had higher than normal returns, which is when returns going forward are low," argues William Bernstein, author of The Intelligent Asset Allocator. The bottom line is that commodities might be useful as a small part of your portfolio (think single digits), but they won't be a money machine that transforms your lifestyle.

Q What about my biggest investment of all—my house?

A Christopher Van Slyke, a financial planner in La Jolla, Calif., tells clients two things about real estate and retirement. First, before you start counting your profits, think about how much you'll pay for the house you'll live in next. Unless you're willing to move far away, the cost of your empty-nest dream cottage has shot up too. Second, consider the recent explosion in prices an anomaly. "The returns of real estate in the long term are somewhere between corporate bonds and stocks," reckons Van Slyke. Many boomers face another challenge. As pension expert Olivia Mitchell notes on page 82, you won't be able to tap all your home's equity if you've already borrowed heavily against it.

As with stocks, demographics could also dampen home prices as boomers first downsize and then, ahem, move on. Some economists think real estate is even more vulnerable to those trends. "Equities are traded in the global market," says MIT's Poterba. "I presume foreign investors will be somewhat less interested in my four-bedroom colonial." But once again, though this may lower returns, it doesn't necessarily portend a crash. Housing economist Karl Case of Wellesley College notes that boomers span a wide age range. "I'm 60, and if I'm going to be in my house another 20 years, the baby boom still stretches out another 20 years behind me," says Case. "The pattern isn't as cliffy as you might expect." Even if the value of your house slides, Case adds, you have built-in insurance: The cost of the house you're buying will have gone down too.

Q Gee, this is a bit of a comedown. Isn't there anything I can do to reach my goals faster?

A If we've stressed the negatives, it's all to hammer home this crucial point: Asset returns are not in your control. Your retirement plan shouldn't hinge on any best-case scenarios. Instead it should be built around getting the most out of the factors you can control. Fund expenses, for example. If Arnott is right, stocks would beat bonds by about a percentage point, so a fund charging 1.5% in annual expenses is on its way to losing the race before its manager makes his first trade. A solid index fund charges a tiny fraction as much. You can also make sure to minimize taxes. If you have money in taxable accounts, take a serious look at funds that are managed for optimal tax efficiency. Once you've maxed out the match on your 401(k), consider sheltering money in a Roth IRA if you are eligible. You might also convert some of your investments in a traditional IRA to a Roth. With a Roth, you pay your taxes up front; the optimal amount to put in will depend on your current tax bracket and what you expect your future tax bracket will be. But with tax rates near a historical low today even as the government's future obligations keep piling up, there's a solid case for paying at least some taxes ASAP. "Draw a chart of tax rates—if that was a stock, you'd buy it now," says Robert Gordon of Twenty-First Securities in New York City.

But at the top the list of things you can control is how much you save. You need to be aggressive here. That means saving at least 10% of your income, and 15% to 20% if you can possibly swing it, especially if you've gotten off to a late start.

Q Can't I just work longer?

A Don't give yourself that deceptively easy out. Working past 65 can be rewarding—and, as we explain in the next story, it may be your best shot if you hit your mid-sixties light on savings. But don't ease up on investing today with the idea that you can fill the gap by working more later. You may not be able to find or keep a good job. Retirement surveys suggest that most of us stop working earlier than we expect. That might change as the growth of the labor force slows, which could spur companies to recruit older workers. Then again, employers might just offshore even more work than they do now. If you think of your career as a part of your portfolio—call it your labor capital—then assuming that you can squeeze out another two years of earnings is akin to deciding to get 10% a year on stocks. It'd be nice, but it's not entirely up to you.

WHAT LOWER STOCK RETURNS COULD MEAN

The difference between earning 6% and 10% is huge over 20 years, making it all the more important to keep costs down.

NOTES: Expenses do not include funds' transaction costs, which can further erode returns. Index fund expense ratio is 0.2%. SOURCE: SEC fund-cost calculator.

76

RETIREMENT: NOT SO FAR OUT ANYMORE

Get serious about catching up

82

SCHOLAR OF THE BOOMERS' FUTURE

Pension expert Olivia Mitchell

84

THEY GOT OLDER TOO

What the stars of your youth have learned about money

»HOW TO SURVIVE THE MIDLIFE TUG-OF-WAR WITHOUT GOING BROKE

A special tear-out booklet

90

FOREVER YOUNG

You can look and feel younger

98

DAYDREAM BELIEVERS

We show seven boomers how to finance their dreams

WHERE THE BOOMERS STAND

Boomers have more wealth than their parents did...

→RATIO OF WEALTH TO EARNINGS

BOOMERS

2.3 to 1

PREVIOUS GENERATION

2.2 to 1

...but it will have to make up for shrinking pensions, longer lives and higher medical costs.

→WORKERS WITH TRADITIONAL PENSIONS (OF THOSE WITH A PLAN)

TODAY

39%

1981

81%

→JUMP IN MALE LIFE EXPECTANCY AT 65 SINCE 1983 +1.7 years

→OUT-OF-POCKET DOCTOR BILLS, AS A % OF SOCIAL SECURITY BENEFITS:

1980

7%

2030

20%

NOTES: Current wealth-to-earnings ratios and pension data are as of 2004; life expectancies are as of 2001. Medical costs based on Medicare Part B premiums and co-payments.

SOURCES: Boston College Center for Retirement Research, Congressional Budget Office, Survey of Consumer Finances.

In contrast to their freewheelin' image, many boomers are good savers.

Thirteen years after Woodstock, the great '80s bull market took off.

CAN I COUNT ON SOCIAL SECURITY?

Depends on what you mean by "count on." Social Security isn't dying. The question is how much you'll get. The system is fully funded through 2040, when the very youngest boomer will be 76. After that, benefits would have to drop off sharply but wouldn't disappear. Now that assumes that Social Security will draw on its "trust fund" in 10 years, and there's a debate over whether that's real money. (Because the trust fund is invested in special Treasury bonds—payable by the government—taxpayers will still foot the bill.) But the trust fund does represent a serious promise to future retirees, and that's not easy for politicians to back away from. If benefits are reduced, those closest to retirement will likely take the smallest hit. If you are already 55 or over, you're safe—the President took your benefits off the negotiating table, and it's hard to imagine future leaders taking a tougher line. One much-discussed plan would simply slow the rate of benefits growth, which would the cut the Social Security checks of the youngest boomers by roughly 15% if enacted soon. But benefit cuts aren't the only possible fix: Taxes could go up instead.

KEY DATES IN SOCIAL SECURITY

First boomers can collect benefits (at age 62).

2008

$2.4 TRILLION

GEORGE W. BUSH born 1946

First boomers turn 65.

2011

$3.2 TRILLION

System begins paying out more than it takes in.

2017

$4.7 TRILLION

TRUST-FUND ASSETS

Social Security trust fund peaks.

2026

$5.9 TRILLION

STEPHEN COLBERT born 1964

Last boomers turn 65.

2029

$5.6 TRILLION

Trust fund runs out. First boomers are 94; last are 76.

2040

$0

NOTE: Trust-fund assets based on intermediate projections.

SOURCES: Social Security Administration, U.S. Census Bureau.