MONEY

Dreaming Of Early Retirement? Three Secrets To Making It Work

Bill and Christina Balderaz, 39 and 37, Upper Arlington, Ohio. The couple got a windfall when Bill's company was sold. But in hopes of retiring before 60, they continue to spend as carefully as before. Sam Comen

Funding your retirement, never a breeze, has become tougher in this economy. Interest rates are hovering near historic lows, and bond guru Bill Gross recently warned that low rates may persist for decades. So what you can earn on low-risk cash and bonds will remain paltry.

Wade Pfau, a researcher and professor at the American College of Financial Services, has calculated sure-fire retirement savings rates in this rate environment.

If you hope to retire at age 65 and start saving at 35 — when baby boomers typically began, a May 2013 Bank of America Merrill Edge survey found — it’s 15% to 19% a year. Move your retirement date up by five years, and those rates go to 23% to 29%, Pfau says.

You probably can’t hit those daunting targets year in, year out. So the trick is to gain ground when you can — and be willing to make the math work by living on less.

What to do

Buckle down. You can catch up with bursts of savings — often easier once big expenses like college or a mortgage fall away.

According to retirement research firm Hearts & Wallets, saving 15% or more of your income for eight to 10 years — early or late in your career — can ensure that you save enough to retire comfortably at 65. Such power saving is common among early retirees too, says Hearts & Wallets co-founder Laura Varas, but the rate is 25% or more.

Related: 10 Best Places to Retire

Calvin Lawrence was able to retire from his job as executive director at Corinthian College in Chesapeake, Va., four years ago at 59, even though he hadn’t gotten serious about retirement planning until after he divorced at 50.

At that point he had about $200,000 set aside. With his two children out of college (and out of the house), tuition and other child-care bills were gone. And a promotion had boosted his pay by $20,000.

Even though he made $110,000 a year, “I lived like I earned $50,000,” says Lawrence, now 63. “I found that I don’t need to spend a whole lot of money to be happy.” The result: He built his savings to $800,000.

Put windfalls to work. Whether it’s an inheritance or a bonus, a windfall can make the difference between leaving early and working until 65.

When Bill Balderaz, now 39, sold the social media marketing business he founded in 2011, he and his wife, Christina, an elementary-school teacher, put themselves on the road to retirement in their fifties. With profits of a few hundred thousand dollars, the couple wiped out the big expenses that often make saving for the future hard — paying off the mortgage on their home in Upper Arlington, Ohio, and setting aside public school college tuition for their kids. The rest went toward retirement funds, which now total $600,000.

Related: Will you have enough to retire?

Just as critically, they didn’t ratchet up their spending. “We didn’t buy a Mercedes or build a new house or send our kids to private schools,” says Bill, now president of Fathom Columbus, the online marketing firm that bought him out.

He still drives a 17-year-old Toyota Tacoma pickup truck. In the market for a boat for the family — the children range from 10 months to 11 years — he bought a decade-old 18-footer off Craigslist for $9,000. A similar new one would have cost $27,000. “We live like the acquisition didn’t happen,” Bill says.

Set low expectations. To get away with saving less, commit to living on less. Planners typically suggest you aim to replace 70% to 80% of your pre-retirement income, which doesn’t amount to a dramatic lifestyle change once you eliminate the money you were saving, Social Security taxes, and commuting costs.

If you can make it on 50%, you need to save 11.8 times your income by age 60, vs. 17 times if you hope to live on 70%, says Charles Farrell, CEO of Northstar Investment Advisors.

As you’ll see in rule No. 3, housing could be the key to doing this. Plus, “people who want to retire early are usually already living well below their means,” notes Farrell. “This might not be a big change.”

MORE: New rules for early retirement

Rule 1: Early retirees: Don’t fear losing your health insurance

Rule 3: Use your home to boost retirement savings

Rule 4: Get the first decade of retirement right

Rule 5: Retiring? Time to look for a part-time gig

MONEY

Early retirees: Don’t fear losing your health insurance

Health insurance has long been one of the biggest obstacles to early retirement. Few employers offer coverage — just 18% of current private-sector workers are eligible for pre-65 retiree benefits, vs. 29% in 1997, according to EBRI.

And buying a policy on the private market before you qualify for Medicare at 65 has been a challenge: A condition like diabetes or heart disease can leave you uninsurable, while even healthy 50- and 60-year-olds pay far more than young people for the same coverage.

A recent Center for Retirement Research study found that the spike in retirement at 65 is due in large part to Medicare eligibility.

Under health reform, all that is poised to change. Regardless of your health, you can buy a comprehensive insurance policy through the state online exchanges that went live Oct. 1. Your age will still push up your premium, but a 60-year-old can’t be charged more than three times what a 20-year-old pays, down from today’s typical 5-to-1 ratio.

“Early retirees will be the biggest beneficiaries of the exchanges,” says Caroline Pearson, vice president at the consulting group Avalere Health.

What to do

Put a price tag on it. Obamacare means you can’t be turned down or charged more for health reasons, but it doesn’t necessarily mean a policy will be cheap. In the 36 states where the federal government is operating exchanges, monthly premiums for mid-level plans are averaging $432 for a 55-year-old and $526 for a 60-year-old, says Carrie McLean, head of customer care at eHealthInsurance.com; rates for a 55- to 64-year-old on the private market today average $329.

But that price difference reflects more robust coverage. A bare-bones policy you could buy this year might carry a $10,000 deductible or omit prescription-drug coverage — required for policies sold on the exchanges. Your combined deductible and out-of-pocket costs will also be capped, at $6,350 for an individual and $12,700 for a family.

“The insurance market is pretty scary for early retirees right now,” says Karen Pollitz, a senior fellow at the Kaiser Family Foundation. “It won’t be so scary anymore.”

Start at healthcare.gov to find options in your state. Heavy traffic and tech glitches made applying a headache right after enrollment opened, but you have until Dec. 15 to sign up for coverage starting on Jan. 1.

Check for price cuts. The premium is just the sticker price. About half of those who buy insurance on their own today will qualify for a subsidy, estimates Kaiser. And since that help is based on how much of your income must go toward insurance, an early retiree with a high premium has a good chance of qualifying for a break, especially if retirement means living on less.

A 60-year-old couple making $62,000, for example, would qualify for a subsidy that would bring a $1,140 monthly payment down to $491, according to the Kaiser Family Foundation subsidy calculator (available at kff.org). For a single person, the annual income cutoff to qualify for a subsidy is $45,000; for a family of four, it’s $94,000.

All that is good news for 62-year-old Sheri Pyle, who retired to Henry, Tenn., last year with her husband, Bill, 18 months after he left his job at a family-owned heating and plumbing firm at 62. Weary of Chicago winters and 60-hour workweeks, the couple dreamed of spending their days in warmer climes, camping, fishing, and volunteering. They now pitch in at the county search and rescue.

“We wanted to quit working while we’re still young enough to enjoy our lives and give back,” says Sheri, who managed the accounting department for a food manufacturer. Bill, now 65, qualifies for Medicare. But Sheri, who has arthritis, has been worried about her insurance costs once her former employer’s $400-a-month COBRA coverage ends in December. On the Tennessee exchange her monthly premium would run $593 for a midlevel plan. But she’ll qualify for a subsidy that will knock it down to $345.

 

MONEY real estate

Best Places to Retire

Love the culture and excitement of urban life, but loathe the congestion and cost? One of these ‘second cities’ could be your first-choice retirement spot.

If the thought of retiring to a sleepy beach town or country hamlet bores you silly, you’re not alone. Increasingly, retirees are “interested in urban center communities,” says John McIlwain, senior fellow at the Urban Land Institute. “They don’t want to be isolated out in the suburbs.” It’s not surprising that people want to spend their post-work years surrounded by the arts, cutting-edge health care, and diverse neighbors, but the cons of urban living (like cost) can be daunting. So we set out to find places that won’t ding your nest egg with high taxes and nosebleed prices, yet still have great attractions and plenty of your peers. Here are five affordable small cities you may one day want to call home.

  • Boise, Idaho

    © imagebroker / Alamy

    Moving to a mountain town means easy access to skiing, hiking, golf, fly-fishing, and more. Unfortunately, it also usually means jaw-dropping home prices, a dinky airport, limited health care, and tourists galore. Not in Boise.

    Yes, locals here can ski at Bogus Basin 16 miles from downtown, stroll or bike 85 miles of trails, and paddle or fish on the Boise River, which runs through town. But they’ll also find low taxes and affordable homes.

    Plus, Boise has become a nucleus of culture and health care. Saint Alphonsus Regional Medical Center is ranked in the top 5% of hospitals nationwide for clinical performance.

    Where to live

    North and East of downtown: Prices in the city center are steep, so buyers should concentrate on the surrounding neighborhoods, says Boise real estate broker Jason G. Smith. “Traffic isn’t an issue,” he says. “So you don’t need to be right downtown to enjoy it.”

    You’ll find two-bedroom condos or small single-family houses priced at about $300,000 in the North End.
    Southeast and Northwest Boise: On a tighter budget? Head to these neighborhoods (located about 10 minutes from the city center) for homes starting around $200,000.

    What to do

    Outdoors: Walk along the Boise River Greenbelt or explore the trails winding out of Hull’s Gulch or Camel’s Back Park. The city has two open-air Saturday markets, which are a great place to find produce and bump into friends.
    Art: The Boise Art Museum has 3,000 permanent works and presents diverse exhibitions ranging from site-specific installations to collections of ancient artifacts.
    Performance: Grab tickets for the opera, philharmonic, or ballet. Boise State’s Morrison Center hosts national tours of Broadway shows, stand-up comedy, and live music, while the Shakespeare Festival fills a 770-seat outdoor amphitheater.

    And there’s more to come: Construction is under way for a new $70 million, 65,000-square-foot cultural center, slated to open in 2015.

    Taxes

    Retirement benefits are taxed, though some types of pensions qualify for a deduction. There is no inheritance or estate tax.

    • Income tax: Highest is 7.4%
    • Sales tax: 6%
    • Median property tax: $1,230
  • Spokane, Wash.

    © Andre Jenny / Alamy

    Unlike gloomy Seattle, Spokane basks in about 260 days of sunshine a year. Want to get out and soak up that vitamin D? The Spokane area has 76 lakes and five ski resorts, plus plenty of golf courses and wineries.

    The city has urban appeal too, with a downtown that’s become a destination for retirees looking to trade high maintenance homes for condos that are walking distance from restaurants, art galleries, and theaters.

    Spokane residents do pay a hefty 8.7% sales tax, but the state has no income tax.

MONEY retirement planning

Get your spouse on the same page about retirement

You’ve got your dream retirement all figured out … but does your fantasy match your spouse’s?

With only 38% of couples planning together, as a 2013 study from Hearts & Wallets found, it’s no surprise that nearly two-thirds don’t agree on when they’ll each leave their jobs, and a third aren’t in sync on where they’ll live.

“Most couples avoid having these conversations because they know there’s conflict,” says psychologist Dorian Mintzer, co-author of The Couple’s Retirement Puzzle.

But the sooner you air expectations, the better your odds of having a retirement that will make you both happy.

The Ground Rules

Prioritize your wants. Suggest that you and your spouse independently make lists of what you want from your retirement before you chat. This ensures everything gets out in the open, says Jan Cullinane, co-author of The New Retirement.

Ditch the “all-me” attitude. Making your wants clear is necessary, but for the best result, avoid pitting your vision against your partner’s. Listen without interrupting, repeat back responses, and avoid criticizing.

When You’re Face to Face…

1. Opening gambit: “We haven’t really ever discussed what we want to do when we retire. Can we set aside time to talk?”

Why it works: You’re easing in by focusing on what will make you happy. “Asking ‘What are your goals for this stage of life, and what will fill your hours?’ will help you figure out what retirement means to both of you,” says Bart Astor, author of The Roadmap for the Rest of Your Life. This can also tee up a discussion of timing.

2. Explain concerns: “You said that you’d like for us to retire together in 10 years. Because I’m younger, I worry that I’d end up having to quit at the peak of my career.”

Why it works: Repeating a partner’s point shows you appreciate his or her view but also gives you a chance to subtly raise concerns and alternatives in a way that feels collaborative.

Age differences and life expectancy — however tough to discuss — must be brought to bear, since wives tend to be younger than their husbands and usually outlive them, Cullinane notes.

3. Talk money: “Let’s go through our finances and see if we can afford some of these ideas.”

Why it works: Once you understand the realities of your budget, you can better prioritize competing goals, says San Diego financial planner Andrew Russell.

You may want to sit down for a session with a financial planner, who can help you run scenarios (figuring out when to claim Social Security is a particularly hairy challenge) and who can also serve as arbiter to keep emotion out of the discussion.

4. Know the backstory: “Can you tell me why it’s important to you that we buy a condo on the beach?”

Why it works: Focusing on the “why” vs. the “what” pushes you toward compromises that reach the heart of both your desires, and are within the terms of your budget. This also makes it less likely either of you will see concessions as losses.

5. Go to middle ground: “Since we both want to retire by 67 and live an hour from the grandkids, how about we work on a plan around that?”

Why it works: Even if you can’t agree on specifics yet, stressing your similarities can help you move ahead on a general path that places your wants as a couple first. “But don’t feel like the plan is set in stone,” says Mintzer. “Revisit it as often as you would your portfolio.”

MONEY annuities

Buying an Annuity for Retirement Income? Think Twice

Eyeing a variable annuity to help bring in more retirement income? Or already have one? The terms are changing to make payouts less generous, so you'll have to decide whether to fish or cut bait.

Get a minimum income for life, no matter what. That compelling sales pitch has propelled investors to pour $1.5 trillion into variable annuities in the past decade.

Driving most of those sales was not the annuity itself, essentially a tax-deferred investment account; rather, buyers have been attracted by the “living benefit” rider, an optional feature ensuring that you can draw a base income from your investments regardless of how the markets perform or whether you drain your account.

Before the financial crisis, riders commonly guaranteed impressive returns of 8%-plus and annual withdrawals around 7%. So it was no wonder that over a period that included two bear markets Americans eagerly rushed into these insurance products, seeing them as the antidote to investment risk.

These days, however, the variable annuity and rider combination isn’t looking like the panacea it once seemed to be.

Over the past 18 months, most of the insurers that sell these products have seriously scaled back guarantees offered on new contracts while hiking fees and restricting investment allocations on both new and existing policies.

Seven major firms, including AXA, John Hancock, and Prudential, have limited or prohibited additional investments in some of their older, more generous contracts. A few companies have even offered buyouts to customers willing to cancel the rider.

Meanwhile, the Securities and Exchange Commission is now looking into whether buyers were ever made fully aware of the potential for such changes.

What’s going on? First, the financial crisis tanked customers’ portfolios, putting insurers on the hook for billions in guarantees on pre-2008 contracts. Since then, years of low interest rates have left firms uncertain that they will be able to satisfy future payouts.

“A lot of companies got burned,” says Moshe Milevsky, a finance professor at Toronto’s York University. Besides rejiggering the terms on their contracts, many insurers have reduced the number of policies they sell; last year two big names — Hartford and Sun Life — dropped out of the business altogether.

Related: The Social Security mistake that could cost you thousands

If you have a VA or were thinking of buying one, you’re probably wondering where all this leaves you. For owners, the answer depends on your contract, your account value, and the changes to your terms.

For income shoppers, it ultimately comes down to what risks you can accept — though there are cheaper, simpler, and more profitable ways to ensure that you won’t outlive your money.

The sections that follow will help you make the right decision for you.

What the changes mean

While each insurer is tweaking its terms differently, there are a few common threads: limited investment freedom, tightened minimum-return and income guarantees, and higher fees.

The most common — and arguably most impactful — shift has been to cap owners’ stock allocation. Through the VA itself, investors used to be able to choose from a large menu of mutual funds. You could go whole hog into stocks, if you so desired, knowing you had the rider’s guarantees as a backstop.

Related: Annuity payment calculator

Today most buyers who opt for a rider — 88% do, says research firm LIMRA — will see their stock stake capped at around 60%. You may also be required to use model portfolios or “managed-volatility” funds, which automatically shift assets from stocks to more conservative choices if your account value falls a certain percentage within a short time.

Such restrictions can have a huge impact on the value of the rider because of how the vehicle is structured.

First thing to know: While the actual money you’ve stashed in a VA-with-rider fluctuates with the value of your investments, a hypothetical account called a benefit base grows at a minimum “roll-up” rate each year — say, 5% — even if your real-life investments lose money. If your actual investments do better than this guaranteed return, the benefit base is increased, or “stepped up,” to match them.

The rider also has a set schedule of guaranteed withdrawal rates based on the age you start collecting. Whenever you decide to start taking income, the percentage is applied to your benefit base to determine the amount. Then the money is drawn from your actual account.

You can generally tap the account for more, if needed, as well, though it will affect your future income. In the most popular kind of rider, known as the guaranteed minimum withdrawal benefit, the insurance kicks in once withdrawals drain the account, allowing you to continue receiving the same amount for as long as you live. (If you die before depleting the account, your heirs get what’s left.)

Investment restrictions decrease the chances that your portfolio will suffer a major downturn, thus decreasing the chances the insurance will come into play at all. Also, the smaller your stock allocation, the less potential for step-ups. “If you’re forced to have a balanced allocation, what’s the point of buying protection?” asks Milevsky.

Changes in guaranteed income further diminish the rider’s value. Two years ago 70% of riders offered a 5% withdrawal rate. Now less than 50% do, says Morningstar.

A lower withdrawal rate means it takes longer for your account to run out and longer for the insurer to have to shell out its own money. Roll-up rates have drifted down too, from a typical 8% to around 5%, and some companies have found ways to further limit them (such as capping the number of years).

More: Rising fees

Then there are the fees.The average toll for the popular minimum withdrawal benefit rose from just under 1% in 2009 to about 1.25% as of December, says Morningstar. Add to that the hefty costs of the base VA itself and expenses end up biting off 3.7%, on average, of the account value per year, according to the latest figures.

Over time that severely crimps your portfolio’s ability to grow. Even after a bear market like the one in the 2000s, $100,000 in a mutual fund portfolio of 60% large-cap stocks and 40% intermediate-term bonds (assuming 0.75% in fees) would have grown to around $131,600 in 10 years. The same investment in today’s average VA rider would be worth only $95,500.

Bottom line: These changes greatly reduce the payouts possible compared with past contracts. In a bull market, you’re looking at thousands less in annual income.

The cutbacks give ammunition to the product’s detractors, who have long argued that high fees eroded VAs’ supposed benefits. “The upside potential on these is just a marketing fantasy,” says Scott Witt, a Milwaukee-area actuary and fee-only insurance adviser.

Proponents counter that the products allow investors who remain scared stiff by the markets to feel comfortable with a bigger stash of stocks. VA riders “deliver peace of mind through guarantees of lifetime income, which can be especially valuable in an uncertain economic environment,” says Whit Cornman, a spokesman for the American Council of Life Insurers.

Related: How much will you need for retirement?

But even some fans say that skimpier riders have made them less likely to recommend the products. “Today’s benefits are so inferior,” says Scott Stolz, president of the insurance group at financial advisory firm Raymond James.

What to do if you already have a VA-rider combo

Know what you’re in for: Owners with contracts written before 2011 have been most vulnerable to term revisions. Thus far the most common changes have been to restrict stock allocation or force customers into more conservative options, to raise fees on the riders, and to limit additional contributions (guarantees haven’t been touched for existing policyholders).

The fine print in the contracts generally allows your insurer to make these types of revisions, though the company will be required to inform you when terms are amended.

Haven’t heard anything yet? You are not necessarily in the clear, says Stolz of Raymond James: “The longer interest rates stay low, or if there is a significant drop in the stock market, the more companies will feel a need to make changes.”

Evaluate your guarantee. If you’re being hit with a change, you have two choices: Accept the new terms and keep the contract, or cancel and find an alternative investment.

One way to make this decision is to look at the difference between your benefit base and the account value: If the former is at least 15% higher, you should probably keep the rider, says Wheaton, Ill., financial planner Robert O’Dell.

Calculating how much income you could take right now can also help you benchmark, says Stolz.

Start by multiplying your withdrawal rate by your benefit base; for example, 5.5% of a $500,000 benefit base is $27,500 a year. Next, compute what percentage of your actual account balance that income represents. On a balance of $435,000, $27,500 represents 6.3% — much more than the 4% initial maximum that financial planners would recommend drawing from a portfolio to sustain a long retirement.

“It’s an indicator of value,” Stolz says, one that would probably outweigh the effect of any higher fee or investment change.

What if you’re offered cash to drop the rider? Offers can be tempting (Hartford, for example, is dangling up to 20% of the benefit base for certain accounts). But as David Blanchett, Morningstar’s head of retirement research, points out, “If the insurer wants to buy your policy, taking the cash probably isn’t a very good deal for you.”

You’re likely to have a valuable guarantee that the company doesn’t want to get stuck paying.

Keeping it? Start drawing now. An analysis published in February by York University’s Milevsky concluded that most owners of older rider contracts should take income sooner rather than later. Essentially, he said, at age 65 and beyond, the income from taking payments now outweighs any increase you might achieve through step-ups in your account value down the road.

Related: Can you afford to retire?

“The sooner you run down the VA and get the account to ruin, the quicker you start living off the insurance company’s dime and stop paying insurance fees,” his report says.

That said, if the percentage you can withdraw goes up with age and you’re close to a break point — you’re 69, say, and the percentage goes from 5% to 5.5% at 70 — wait until then.

Ditching it? Minimize your costs. Early on, variable-annuity owners are hit with a charge on the way out the door. These “surrender fees” usually decline over five to seven years — say, from 8% the first year down to 2% in the seventh. Wait to cancel until the percentage owed falls below the annual expenses you’re paying so as to avoid losing a lot of your investment value.

Also, be aware that if you own the VA outside an IRA, canceling could trigger a big tax liability: You’ll owe ordinary income taxes on investment gains.

You can avoid those by exchanging the annuity for another in what’s called a 1035 exchange, says financial planner O’Dell. See the next section for alternative products that can secure your income. Just make sure to get 1035 forms from the insurer.

More: What to do if you’re shopping for income

What to do if you’re shopping for income

Take stock of your stock anxiety. Even before the changes in rider terms, “there were cheaper ways of guaranteeing income,” says insurance adviser Witt.

Still, the product can make sense for certain people — in particular, those so fearful of another 2008 that they’re taking much less risk than they should. For such individuals, a VA-rider combo presents a shot at growth, notes Miami financial planner Bruce Cacho-Negrete.

To overcome the fees, though, you need to be mostly in stocks, he adds: “If you can’t get at least 80% exposure, it’s harder to make the case for these.” (Right now only one insurer, Jackson National, lets you go in that deep.)

Invest conservatively now, annuitize later … Got a stronger stomach? You’ll have potential for more income if you stash your money in a conservative, low-fee mutual fund portfolio until you need income, then purchase an immediate annuity at that time.

With this type of annuity, you hand over a lump sum to the insurer and start getting paid immediately. Unlike the VA, the amount you invest is the insurer’s to keep even if you die the next day. But payouts are higher, since insurers can transfer premiums of those who die early to those who live longer.

Currently, a 65-year-old man investing $100,000 could get $6,800 a year. The size of the check depends on your age and interest rates at the time of purchase, though — good reasons to wait to buy. (Find quotes at ImmediateAnnuities.com.)

Related: What are the different types of annuities?

Last September, Wade Pfau, a researcher at the American College of Financial Services, analyzed various income strategies for a 65-year-old couple, including immediate annuities, a VA-rider combo, stocks, and bonds.

His conclusion: A mix of stocks and immediate annuities provided the best balance of guaranteed income and flexibility to draw from savings for lifestyle needs or to cover emergencies. The exact percentages of each, he says, depend on your preference for meeting a spending goal, vs. having leftover wealth. But, Pfau adds, “50% stocks/50% annuity could be a pretty good mix.”

…Or nail down later income now. An alternative strategy would be to buy a deferred-income annuity, similar to an immediate annuity except that it allows you to lock in future income. You buy now and delay paychecks anywhere from 13 months to 45 years. A 65-year-old man with $100,000 can buy $16,520 a year starting at age 75; if he waits until 85 to start collecting, he’ll get $62,950.

The reason for the gaping difference: the increased likelihood he will die between 75 and 85 and the insurer will pocket the money. (Shop for these, too, at ImmediateAnnuities.com, but be aware that a deferred annuity is different from a deferred-income annuity.)

Related: Want $1 million? Protect your portfolio

On the upside, this method cuts out investment risk in the period before you need income. Downside: You lose the potential for market rallies that would boost your portfolio and interest rate hikes that would make the contract more productive.

The most effective way to use a deferred-income annuity is to buy one with a slim slice of your portfolio and push the income way into the future, says Pfau. The goal: to ensure you’ll have some income in your later years if your portfolio runs dry. You’ll pay much less for that security than you would for a variable annuity.

MONEY

Maxed out Your 401(k)? Here’s How to Save More for Retirement

B.A.E. Inc.—Alamy

My 401(k) contribution has been capped at 6%. How do I save more for retirement? — Frankie L., Arlington, Va.

As you’ve found, the IRS limits 401(k) contributions by high earners — chiefly those who earned more than $115,000 in 2012 — unless their company ensures that lower-paid workers are also saving for retirement.

Start by putting $5,500 ($6,500 if you’re at least 50 by year-end) into a Roth IRA, which offers tax-free withdrawals in retirement, says Moline, III., financial planner Marty Kurtz.

In 2013 your allowed contribution falls to zero if your income tops $188,000 ($127,000 if you’re single), but anyone under 70½ with earnings can fund a nondeductible IRA and then convert it to a Roth. But you may owe taxes on this back-door deposit if you have other traditional IRAs.

Then buy low-fee, tax-efficient funds in a taxable account, says Kurtz. Index funds work well; their infrequent trading minimizes taxable gains.

MONEY Ask the Expert

Investing Beyond Your Target-Date Fund

Many investors combine their target-date fund with one or more other investments. illustration: paul blow

Q. “I already invest in a target-date retirement fund. What should my next fund be?”– Errick Chiasson, Baldwinsville, N.Y.

A. Target-date funds are designed to provide not only a fully diversified portfolio in a single fund, but also an investing strategy. Their mix of stocks and bonds gradually becomes more conservative as you age, protecting your savings as you near retirement. So in theory these funds work best if you put your entire 401(k) into one.

In the real world, however, many savers don’t take such an exclusive approach. A recent Vanguard survey found that just under half of target-date investors in its 401(k) plans combine target funds with one or more other investments, in some cases even another target fund.

While mixing another fund with a target fund can be a reasonable choice, you have to be careful that doing so doesn’t leave you with an unruly mishmash instead of a coherent portfolio.

Straying from the target

One good reason for going beyond a target fund is to adjust how much risk you’re taking.

Let’s say you’re a young investor who likes the target-date concept because it frees you from having to create a portfolio on your own, but you’re anxious about having 90% of your money in stocks, a typical allocation for investors in their twenties and thirties. Transferring, say, 20% of your target fund’s balance into a diversified bond fund would give you a considerably less volatile portfolio.

Conversely, you could make a similar shift into a total stock market index fund to boost your 401(k)’s growth potential. This add-on strategy is a more effective way to tweak risk than picking a target fund with a later or earlier retirement date.

Once you get beyond this sort of simple fine-tuning, however, things can get hairy. Some investors employ a “core and explore” strategy in which they use a target fund as a foundation and then add funds that focus on certain sectors, such as emerging markets or real estate.

Problem is, most target funds already spread their assets widely both here and abroad. So you could end up doubling down on niche markets.

Besides, you may not enjoy enough extra return to make up for the added time and trouble of monitoring and re-balancing a considerably more complicated portfolio.

If you do go that route, plug all your retirement investments, including those outside your 401(k), into Morningstar’s Portfolio X-Ray tool (available free at troweprice.com). That way you can see your overall allocation and make sure you’re not inadvertently overweighting any areas.

But once you’re investing in so many other funds that your target fund essentially becomes a bit player, you may be better off simply building a portfolio from scratch.

MONEY

3 basic steps to creating a retirement plan

I’m 40 and would like to begin preparing for retirement, but I don’t know what to do. How should I start? — Nick Z., Astoria, N.Y.

You, sir, need a plan.

A recent survey shows that people who’ve prepared a personal financial plan are more likely to feel as if they’re on track to meet financial goals, like saving for retirement.That makes perfect sense, since it’s hard to know whether you’re on course if you haven’t mapped one out.

Similarly, stats from the Employee Benefit Research Institute’s Retirement Confidence Survey demonstrate that people who’ve made an attempt to calculate how much they’ll need for retirement not only are more likely to put money away, they also aspire to higher savings targets.

But the payoff you get from planning extends beyond having a greater chance of achieving a secure and comfortable retirement down the road. Research also confirms that people who take control of their finances tend to be happier about their lives than those who don’t. In effect, you get to reap at least some of the reward of planning and saving for retirement before you actually retire.

So, how can you create a retirement plan that can help you simultaneously feel better about your life today and improve your retirement prospects down the road? Here’s a three-step guide:

1. Take stock of where you stand now: Start by pulling together the current balances of any money you have tucked away for retirement in all types of accounts — 401(k)s, IRAs, other company savings plans, even savings earmarked for retirement that are held in taxable accounts.

After you’ve added up all the balances, estimate the percentage of your total savings you have in each of these three broad asset categories: stocks (including stock mutual funds), bonds (and bond mutual funds) and cash equivalents (money-market funds, money-market accounts, CDs, etc.)

Related: Americans still worried about their financial future

Then calculate the percentage of your gross annual income that you save in a 401(k) or other workplace plans (including any company matching funds) and note the dollar amount that you stash in investments outside your workplace plan.

2. Plug this information into a good retirement calculator. By “good,” I mean a calculator that employes Monte Carlo-type simulations to allow for the variability in investment returns.

Among the free online calculators that do this are T. Rowe Price’s Retirement Income Calculator and Fidelity’s Retirement Quick Check.

In addition to the savings and investment information I mentioned above, you’ll also want to include an estimate of the age you intend to retire, your projected Social Security benefit and the percentage of your pre-retirement salary you’ll need to maintain an acceptable standard of living in retirement.

Clearly, the younger you are, the “squishier” these estimates are likely to be. Just do your best and be reasonable.

If you’re 40 and just beginning to save, then it would probably be unrealistic to expect to retire anytime before your mid-to-late ’60s, and even that may be ambitious.

As for the percentage of pre-retirement income you’ll require, anywhere between 70% to 90% is a credible estimate. You can get your projected Social Security benefit by going to Social Security’s Retirement Estimator.

Once you’ve loaded all this information into the calculator, you’ll get an estimate of the probability you’ll be able to retire at the age you indicated with the income you specified. If you haven’t been saving and investing regularly for retirement, your chances are probably going to be uncomfortably low — maybe even well below 50%.

But don’t panic. Your goal at this point is to improve your prospects as much as possible in the time you have left. The way to do that is to rerun the analysis with different assumptions to see which changes, alone and in combination with others, improve your outlook the most.

Related: Make your money last all through retirement

What you’ll likely find is that you’ll get the biggest boost by saving more and postponing retirement a few years. Investing more aggressively isn’t likely to help as much, and could backfire.

Even though investing better isn’t likely to improve your outlook as much as saving more or working a few more years, you don’t want to squander your savings on a haphazard investment strategy or foolish investments.

So I recommend you settle on an asset allocation, or stocks-bonds mix, that’s appropriate for your age and, aside from occasional rebalancing, leave it alone, except to shift more toward bonds as you get closer to retirement. Creating as much of that portfolio as possible with index funds will hold costs down and increase your potential return. If you’re not confident about your ability to build a portfolio on your own, you can invest in a target-date retirement fund or use one as a guide for creating your own portfolio.

3. Follow through — and periodically reassess. All this effort will be for naught, however, if you don’t actually put the plan into place and, most importantly, save as much as you can.

You’ll get the biggest bang for your savings buck by contributing to tax-advantaged plans like a 401(k) or IRA. If the 401(k) offers matching funds, be sure to contribute at least enough to get the full match.

Once you’ve exhausted your tax-advantaged options, you can move on to tax-efficient investments, such as index funds, ETFs or tax-managed funds, in taxable accounts.

Related: Social Security’s role in your retirement portfolio

Retirement planning isn’t something you do once and then forget about it.You’ll need to periodically assess your progress and make adjustments to stay on track. So go through the process I’ve outlined every couple of years, stepping up the frequency to annually as your career winds down.

When you’re within ten or so years of your anticipated retirement date, you could very well find that, despite your best efforts, you haven’t accumulated enough resources to allow you to retire on schedule and lead the lifestyle you’d like. At that point, you can weigh options such as working longer, taking a part-time gig in retirement, scaling back your post-career lifestyle or looking for ways to stretch your resources by, say, taking out a reverse mortgage or relocating to an area with lower living costs.

Ultimately, no plan can guarantee you’ll be able to achieve the retirement you envision. But I can assure you that your chances of retiring in comfort will be much, much lower if you don’t have a plan at all.

MONEY Ask the Expert

Where Social Security Fits in Your Retirement Portfolio

Q. Can I consider Social Security the bond portion of my portfolio and invest a higher percentage of my savings in stocks? — Michael H., Pittsboro, Ind.

A. Social Security does function somewhat like a bond in that it provides steady income (although unlike most bond payments, Social Security’s payouts increase with inflation). So, in theory at least, it makes sense to factor in your Social Security benefit when deciding how to invest your savings in retirement.

As a practical matter, however, you need to be careful about how far you take this notion, as you could end up with a portfolio that many retirees might consider too risky.

Here’s an example. Let’s assume you retire at age 66 and that you need real, or inflation-adjusted, income of $60,000 a year, $20,000 of which will come from Social Security. And let’s also say youhave $1 million in savings and that you divvy up that nest egg equally between stocks and bonds in order to have a reasonable balance between long-term growth and short-term protection against market setbacks.

If you think of Social Security only as a stream of income and forget about the fact that it’s also kind of like a bond,then the issue you face boils down to how to get the rest of the income you need from your $1 million nest egg. If you go to an online retirement calculator, plug in savings of $1 million,an allocation of50% in stocks and 50% in bonds and assume a $40,000 initial withdrawal that is annually increased by inflation, you’ll see that there’s a roughly 80% chance your savings will last at least 30 years.

But this approach ignores the fact that Social Security also acts somewhat like a big bond.

Indeed, many economists would say that you don’t just have $1 million in assets. You have $1 million, plus a “Social Security” bond that makes inflation-adjusted payments of $20,000 a year. They’d also say that by not taking that bond into account, you may be investing too cautiously, ending up with more in bonds than you should. In so doing, you may be giving up a significant amount of investment return, and extra retirement income.

You can argue about how to set the value of that Social Security bond. But in today’s interest rate environment, William Meyer of Social Security Solutions, a firm that helps people decide when to claim their benefits, estimates its value would be roughly $500,000 for someone whose full retirement age for Social Security purposes is 66 and who begins collecting payments at that age.

Considered from this vantage point, you would have the equivalent of $1.5 million — $1 million in savings, plus a Social Security bond valued at $500,000. Which means if you want to maintain an investment mix of 50% stocks and 50% bonds, you would put $750,000 of your $1 million savings into stocks.

The remaining $250,000 would go into bonds, which, combined with your $500,000 Social Security bond, would give you $750,000 in bonds overall, resulting in an effective 50-50 stocks-bonds split for the $1.5 million.

But here’s the rub: If you look only at the actual assets you have access to — that is, your $1 million in savings — you’ve got 75% in stocks ($750,000 of your $1 million) and 25% in bonds ($250,000 of your $1 million). That’s a pretty aggressive portfolio for a retiree.

Related: 4 ways the market could really surprise you

Meyer agrees that such a high stock stake would “freak out” a lot of people, as it’s more prone to sizable setbacks. But he also argues that the higher volatility of such a portfolio shouldn’t unduly upset you because you also have those guaranteed Social Security payments coming in every month regardless of what’s going on in the financial markets.

So the value of that Social Security bond holds up even when the market is falling apart. Thus, if you take a broader view, your portfolio isn’t as volatile as it may seem.

In a purely logical sense, he’s right. But I’m also reminded of 19th century humorist Edgar William Nye’s famous quote that “Wagner’s music is better than it sounds.” Which is to say that you can’t always go by logic alone, especially when it comes to something like your lifetime savings. You’ve also got to consider the emotional and psychological impact of how you invest that money.

I think most retirees are going to focus on the account balance they can see, the $1 million, not the combination of that amount plus a hypothetical asset value they can’t actually see, or tap into for that matter.

So even if they own the theoretical equivalent of a $500,000 Social Security bond, I’m not sure that most investors would be prepared to handle the volatility of a $1 million nest egg invested 75% in stocks and 25% in bonds if a 50-50 split is more their speed.

Besides, if your nest egg is all you have to get you through emergencies and absorb unexpected costs, it’s important you don’t unduly expose it to the vicissitudes of the market. After all, if that money runs out, it’s not as if you can cash in a portion of your Social Security bond to pay for larger-than-expected health care expenses.

And while a $1 million nest egg invested in a blend of 75% stocks-25% bonds has roughly the same likelihood of generating $40,000 a year throughout retirement as a 50-50 mix does — and could generate even more — you run a larger risk of exhausting your savings if the market takes a dive early in retirement.

Related: Do you need an investment adviser?

That said, I could see situations in which factoring in Social Security might lead you to invest more aggressively.

For example, if Social Security, alone or combined with some other type of guaranteed income, such as a pension, covers so much of your living expenses that a big downturn in the value of your savings wouldn’t force you to scale back your lifestyle, a more stock-heavy portfolio with the potential for higher returns could be a reasonable way to go.

Even then, however, tilting more toward stocks would make sense only if you also have the emotional and psychological tolerance to handle the potentially larger setbacks.

Bottom line: I think you should consider your Social Security payments when deciding how to allocate your savings between stocks and bonds in retirement. Ultimately, though, whatever mix you come up with for the actual savings you have in retirement accounts should be one that has a realistic shot of generating the income you need in retirement –and that you’ll be comfortable sticking with even if the market nose dives.

MONEY Ask the Expert

3 Tips for Talking Retirement With Your Spouse

Have a heart-to-heart conversation about your retirement plans with your spouse. Getty Images

Q. How do I get my spouse on the same page as me when it comes to saving for retirement? — David H.

A. Retirement planning isn’t the most romantic topic in the world, so you may not want to bring this up on Valentine’s Day. But it is important that you and your wife have a tete-a-tete (or heart-to-heart, if you prefer) not just about saving, but about developing a comprehensive strategy to prepare for retirement.

Unfortunately, far too many couples aren’t having such conversations. When Fidelity polled 648 married couples in 2011, for example, a third didn’t agree or didn’t know where they planned to live in retirement, almost half didn’t see eye to eye about whether they would continue to work in retirement and nearly two-thirds disagreed about whether they had a plan to create post-career income.

This failure to communicate can be especially worrisome for women. They’re statistically likely to outlive their spouses, yet because they’re generally not as engaged in investing and planning as their husbands, they’re often not prepared to manage the household finances on their own.

Indeed, only half as many wives as husbands (35% vs. 72%) polled by Fidelity felt completely confident they could take full responsibility for retirement planning.

To assure you’re both on the same page, here are three steps you and your better half should take:

First, do a retirement reality check. Before making any moves, you and your wife need to know whether you’re currently on the path to a secure retirement.

You can do that by revving up an online retirement calculator and plugging in your ages, income, how much you’re saving now, your retirement account balances and the age at which you hope to retire. This will give you an estimate of your chances of being able to achieve your retirement goal if you continue doing what you’re doing.

If those chances are uncomfortably low — say, less than 75% or so — then you and your wife can see how making adjustments, such as saving more or postponing retirement a few years, can boost them.

By doing this sort of analysis together — or at least reviewing the results jointly — you’ll both know where you stand now and what you have to do if you want a reasonable shot at maintaining an acceptable standard of living in retirement.

Second, synchronize your efforts. When it comes to retirement planning, a couple working in unison will do better than each spouse going it alone. If you’re both working, start by making sure that, as a couple, you’re getting the most out of your company retirement plans.

Let’s say one spouse’s 401(k) has a more generous matching policy. In that case, rather than each spouse simply contributing the same percentage of salary to their individual plans, a couple may be able to get a bigger bang from the same total contributions by directing a larger share of their savings to the more generous plan.

Make sure you’re also investing in synch. That not only means agreeing on the appropriate mix of stocks vs. bonds for your household, but that you’re achieving that target most efficiently.

Related: Long-term investing: Keep it simple

For example, if your 401(k) has a good lineup of low-cost stock index funds but underwhelming bond choices, then to the extent possible you’ll want to do your stock investing in your plan and get your bond exposure in your spouse’s plan.

When you’re closing in on retirement, you also need to think hard about coordinating how and when you’ll claim Social Security to maximize your benefits as a couple. Generally, it pays for the spouse who qualifies for a higher benefit to postpone taking it until age 70, while the other spouse begins collecting checks sooner.

Related: Are you saving enough for retirement?

But with so many different scenarios based on a couple’s ages and earnings histories — and since tens or even hundreds of thousands of dollars in benefits is potentially at stake — you may want to check out services such as Social Security Solutions and Maximize My Social Security that, for a fee, can help you find the right strategy for claiming benefits given your situation.

Third, keep in touch with each other. Retirement planning isn’t the sort of thing you do once and then put on autopilot for the next decade. Ideally, you and your spouse should go through this exercise once a year or so, plugging updated information into the calculator and seeing whether you’re still on course.

If you’ve fallen behind, you can then talk about making adjustments to get back on track.

As part of this annual process, you should also review your portfolio to make sure your investment choices have performed in line with their peers and market benchmarks — and, if necessary, bring your overall retirement portfolio back to its target stocks-bonds mix.

So as soon as the mood is right, I recommend you broach the subject of retirement planning with your spouse. It may not go over as well as a dozen roses. But the benefit you and your wife will receive from engaging in this discussion will continue long after the flowers have wilted.

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