The cartoon shows a man looking over his retirement statement. The caption reads: "According to your latest figures, if you retire today, you could live very, very comfortably until 2:00 p.m. tomorrow."

Accumulating enough money for retirement doesn't happen by accident. Developing a realistic long-term plan that takes into account your financial needs and goals provides tremendous benefits. We hope you'll be encouraged as we review proven financial strategies you can use as you move toward and into retirement.

For most of us, the likelihood of enjoying our preferred lifestyle during retirement is heavily dependent on steps we take years before we move into that season of life. The following three financial steps are among the most important you can take before reaching retirement to help guarantee that your retirement lifestyle will meet your expectations.

  1. Be completely debt-free by the time you retire.
    This includes your home mortgage and any college debt you may have incurred for your children. Debt, especially a high mortgage payment, limits investment options and lifestyle flexibility. If you need to add additional principle to today's monthly mortgage payment to pay it off by retirement, do it!
     
  2. Maximize your contributions to your company's retirement plan, such as a 401(k).
    We hope you realize that Social Security will not meet 100% of your retirement needs. Public policy continues to move toward individuals becoming increasingly more responsible for funding their own retirement. The tax-free investment growth and savings discipline that occurs inside your company's retirement plan is difficult to beat. Contributing to an IRA is also a good idea, especially if you're already taking full advantage of any matching within your company retirement plan.
     
  3. Fully fund an emergency savings fund.
    In other words, build your personal liquidity. Why is this important? First, it buys you time. Personal savings will allow you to postpone tapping into your retirement savings for monthly living expenses after the paychecks stop coming in. You will have adequate time to reposition your retirement investment assets, if necessary, and let them continue to grow tax-free. Second, it provides efficiency. If you need $20,000 for a new car, you won't have to take $30,000 out of your retirement funds, pay $10,000 in income taxes, and then have $20,000 left to spend for a car. Again, this allows your long-term investments to continue growing tax-deferred.

How do I invest during retirement?

"How am I going to replace that monthly paycheck?" is typically the first question a newly retired person has. But, is it the right question to ask first? We believe it's merely one of a series of questions that, correctly answered, lead to good investment decisions. Instead of focusing immediately on income, a more appropriate starting point is determining which is of greater concern to you — the short-term risk of market volatility and potentially losing principal in the short run, or losing purchasing power to inflation over your retirement lifetime?

Some retirees are uncomfortable with the idea of ever losing any money. Unfortunately, this mindset limits an investor to only fixed-income investments. With people living longer in retirement, all but the very wealthy need to continue to invest some money in stocks in to keep up with inflation. However, for the non-stock portion of your portfolio, the following are simple strategies to increase income and avoid capital risk:

  1. Don't automatically settle for your local bank's savings account.
    In this era of low interest rates, it can seem like more hassle than it's worth to shop around for an extra 0.25% of interest. But retirees often carry high savings balances that can make even small differences worthwhile.
     
  2. Shop nationally to obtain the highest savings and CD rates.
    Related to the first point above, banks vary widely in the interest rates they pay on CDs. A quick check recently revealed that some local banks were paying as little as 0.02% on money-market accounts(!), whereas some of the better online banks were offering as much as 1.00%. The gap was just as wide for CDs. Ignoring this difference is essentially giving up free money. Given that most of these online banks allow you to link their account to your local bank's so you can transfer funds back and forth electronically, there's no need to do that. Bankrate.com is an excellent place to start your search for higher yields.
     
  3. Build a savings "ladder."
    Longer-term CDs pay higher rates than short-term ones. A good way to obtain the higher rate without sacrificing your liquidity is to build a portfolio of CDs with staggered maturities. This would mean investing in CDs which mature in six months, one year, 18 months, and so on. If you wish, you can extend out as long as five years to get the very highest rate. As each CD matures, roll it over to the most distant maturity (see Shaky Ladder? Using a "CD Ladder" When Rates Are Low).
     
  4. Buy individual bonds.
    A five-year corporate bond may pay 1%-2% more than a five-year CD. While bond values go up and down as interest rates change (as rates rise, bond prices fall, and vice versa), the beauty of buying individual bonds is that as long as you don't sell your bond before it matures, you avoid the risk of loss. How Buying Individual Bonds Protects You From Rising Interest Rates offers details on purchasing individual bonds.
     
  5. For diversification, consider a no-load bond fund.
    Bond funds buy multiple issues of different types of bonds. Their portfolios can be short-term, intermediate-term, or long-term, and vary in the quality of their holdings. With interest rates likely to rise over the next few years, SMI currently is recommending short-term bond funds for most investors, with some intermediate-term bonds for those with a high percentage of their portfolio invested in bonds. See SMI's Asset Allocation Guidelines. One drawback of investing through a bond fund is that it never reaches maturity. This means you can't avoid a potential loss of principal simply by holding the fund long enough. As a result, you need to be prepared to see some fluctuations in principal value. Vanguard is usually the best choice for investors who plan to do considerable bond fund investing.
     
  6. Consider the tax consequences.
    The interest earned on municipal bonds is exempt from federal income taxes. Municipal bonds issued in your state also can save you money on state income taxes. You can invest in them directly, or through tax-free money-market and bond funds. Because municipal bonds are tax-exempt they don't pay as high an interest rate, but remember you need to make the comparison to after-tax income.

Taking a “total return” approach

A retired investor has to weigh the importance of two competing desires. One is the desire to minimize portfolio volatility and not lose money, even over short time periods. If this is a major priority and you have a sufficiently large retirement nest egg, you can stick with income-oriented strategies such as those listed previously and enjoy very little short-term volatility.

But for many, the more pertinent concern is the possibility of running out of money during your (or your spouse's) lifetime. If you're not likely to retire with enough money to simply "live off the interest," this means constructing a retirement portfolio that will grow with inflation and protect your purchasing power and lifestyle. That means continuing to invest a significant portion of your portfolio in stocks. But aren't stocks risky? The traditional answer is "yes." Stocks generally are more volatile than bonds. But because of inflation, volatility isn't the whole picture on risk.

Over time, inflation erodes a dollar's purchasing power. The consumer price index (CPI) measures price increases (and the accompanying loss of buying power) in the economy generally. Of course, the cost of some items rises at an above-average rate. In recent years, medical costs have been a good example of an expense category rising faster than inflation (and one of particular impact for retirees). The $75 office visit five years ago now costs $150+. Looking back over the last 30 years, an item that cost $100 in 1983 would cost $234 today. (See U.S. Inflation Calculator) Thirty years isn't an unusually long period to plan for in retirement, meaning the income generated by that initially impressive-looking nest egg is going to gradually buy less and less unless counter-measures are taken.

The solution then is to continue to invest part of your portfolio in stocks. But with stock dividends at such low levels, many retirees don't like that idea because stocks don't generate enough income. The ideal of "not touching the principal" and living off the interest of a portfolio can be difficult to shake. To get over this mental hurdle, we advise retirees to take a "total return" approach to their income needs. Purely from an income standpoint, would you rather own a bond that yields 3% or a combination stock/bond portfolio that yields 2%? The bond at 3% seems like the logical choice: earnings of 3% on $100,000 in bonds is $3,000 a year, while the 2% yield on the $100,000 stock/bond portfolio offers just $2,000 in income. But the amount of current income obtained from a particular investment shouldn't be the only thing considered in this decision.

Generally speaking, in three out of four years the total return (yield plus capital gains) from a stock portfolio will exceed the total return from an all-bond portfolio. What if, thanks to the stock holdings, the $100,000 stock/bond portfolio grew in value by 5% during the year? When you add the income of $2,000 to the appreciation of $5,000, the total return was $7,000 — considerably more than the return from the bonds. But what if you need the full $3,000 of income to help meet your living expenses? Simply withdraw the difference from the stock/bond portfolio, selling some stock or bond fund shares as needed.

The table below gives two 10-year scenarios. In each case, an annual withdrawal is made that is adjusted upward to keep pace with a 3% rate of inflation (e.g., if income of $3,000 was desired initially, then $3,090 would be needed at the end of Year 1 to maintain purchasing power).

The "fixed income" strategy relies exclusively on bonds and CDs. An average rate of return of 3% is assumed — decidedly low compared to historical averages, but certainly in line with (or even a bit higher than) today's yields. Note that this strategy falls behind almost immediately. The first year's withdrawal, after adjusting for inflation (Col. E), is more than the amount earned (Col. D). A small dollar amount of securities must be sold (Col. F) in order to fund the full payout. This leaves a little less in the account to invest in Year 2 (Col. A), which leads to a slightly greater shortfall that year. Again, securities must be sold to fund the payout. The cycle continues, slowly eating into the principal. Furthermore, the "ending balance" (Col. G) in Year 10 doesn't tell the full story. After adjusting for 3% annual inflation, the principal's purchasing power is shown to be reduced to an even greater extent (Col. H).

Now let's look at the "total return" portfolio consisting of 60% stock funds and 40% bond funds. Returns vary from year to year, but assume they average 7% per year over the entire decade. Again, this is lower than the historical average, but in line with the lower growth expectations many experts seem to have for the stock market going forward. The first year all goes well. The account goes up in value (Col. G), despite withdrawing $3,090 (Col. E). But stocks take a hit in Year 2 (Col. C), pulling the entire portfolio down. Securities must be sold (Col. F) to fund the payout. (The securities to be sold are selected so as to maintain the 60%-to-40% balance going into Year 3.) Briefly, the portfolio is looking worse than the fixed-income strategy.

What does the retiree do when his stock-oriented portfolio loses money? The first thing to remember is that you are investing for the long-term. Over the long haul, periods of 10 years and longer, stocks have consistently produced positive results. Given life expectancies today, most retirees will live for 20-35 years off their portfolios, so a long-term perspective is appropriate.

At the end of the 10 years, the stock/bond portfolio is worth $148,565 compared to $94,074 for the fixed-income strategy. More importantly, it has maintained its purchasing power — it's worth $110,546 in constant dollars. Even after adjusting for inflation, the account has 10.5% more purchasing power than it did when the strategy was launched. The important point to note is that the total-return approach to investing still allows you to take a full annual withdrawal even in years when the market declined or did not return as much as the withdrawal rate. We used the 60/40 portfolio mix in the example because SMI recommends it for investors with five or less years until retirement (assuming one can emotionally accept the risk—see An Upgrading Overview: Easy as 1-2-3).

Turning a portfolio of stocks and bonds into a stream of regular income can seem complicated. It doesn't need to be. It can be as simple as telling your brokerage to sell enough shares of a particular stock or bond fund every quarter to generate a specific income dollar amount. By rebalancing your portfolio every year, you can make sure that your stock/bond allocation stays on track despite the periodic withdrawals. While this approach is attractive in its simplicity — it runs on autopilot once set up — some investors prefer an approach that's more responsive to what's currently happening in the markets.

An optional refinement for those with stock/bond portfolios

The ideal situation for a retiree generating income from a mixed stock/bond portfolio would be to sell stocks only at peaks in the stock market, thus getting top dollar with every sale. Unfortunately, identifying the absolute high and low points of the stock market isn't realistic. It's simply too difficult to do. However, it is reasonable to recognize that along the market's long-term upward path, it takes many detours both up and down. This volatility presents an opportunity to the retiree who is prepared for it.

This is done by combining a money-market account (MMA) with your stock/bond portfolio. By putting three years worth of living expenses (or more specifically, the portion of living expenses to be funded from investments) into the MMA initially, the retiree doesn't need to sell any long-term investments for income unless they wish to, that is, unless an attractive market opportunity presents itself. (Establishing a four- or five-year fund, if you can afford it, would provide even greater flexibility. ) Having the MMA also offers the convenience of drawing your monthly living expenses from it as needed rather than having to sell from your portfolio every month (the MMA could then be replenished when the portfolio holdings are sold on a quarterly or semi-annual basis).

The amount in the MMA will fluctuate between zero and the full three-year amount. During times of poor stock market performance, living expenses would be drawn from your MMA rather than selling any of your stock holdings. This might last for a year or longer. During periods when the market has been doing particularly well, selected stock holdings could be sold and the proceeds placed into the MMA, bringing it back to full strength. Since the market tends to have significant peaks and valleys every three-to-four years on average, it would be rare that a retiree would ever need to sell when stock prices are poor. And even in those events, the sales would occur only after the MMA had been exhausted, meaning fewer sales took place than would otherwise be the case.

So what exactly constitutes an attractive selling opportunity? Remember, we're not talking about calling market tops and bottoms. For the sake of example, consider a retired couple whose budget requires them to supplement their Social Security and pension income with money from their stock/bond portfolio. They establish an MMA with three times their required annual income withdrawals. This can be a difficult task for some, but having that very safe living expense money is what will likely allow them to weather the ups and downs of the markets without sabotaging their portfolio by panicked selling due to fear during bear markets.

Let's think back over the past couple decades to see how this might work. As early as December 1996, Alan Greenspan made his "irrational exuberance" speech, warning that stock prices seemed too high. At that point, our retirees might have sold some of their stock holdings in order to build their MMA to the maximum level. As the market continued higher from 1997-1999, they could have periodically continued to sell a little from their stock holdings to keep the MMA account full. They would have sacrificed some return late in that bull market by having this money parked in savings, but it would have caused the MMA to be full when the bear market began in early 2000.

Because all living expenses can be accounted for in the MMA, our retirees wouldn't have felt any need to sell as prices fell in 2001 and 2002. After two years, their savings account would have been reduced substantially, but if they had started with three years' of reserves, it would still have enough to weather another year without any new selling of stocks or bonds. As the market recovered in 2003, they could have continued to sit tight, further drawing down savings as their stock/bond portfolio regained lost ground.

Our retirees might have started to sell a little from their stock/bond portfolio in 2004 as their MMA savings was finally depleted. An SMI Upgrading portfolio would have recovered to its pre-bear market high mid-way through 2004, so for this couple it would have been as if the bear market was a relatively small bump in the road. As the market continued higher in 2006 and 2007, they could once again refill their savings MMA to its maximum level by selling from their stock holdings at the higher levels. The point is they don't have get the timing exactly right for this idea to still work.

With a fully replenished savings reserve, they're in good shape to once again ride out the bear market of 2008-2009. Again, they spend their savings down until maybe 2011 or 2012, at which point they start selling stocks and bonds again to fill it back up.

While this is just a simple example, you can see that without being very precise at all about the turns in the market, a retiree can still sell into strength and sit tight during weakness if their immediate living expenses are accounted for in the MMA. Of course, this idea only works if the total portfolio size is large enough that having three years (or more) of living expenses in cash isn't going to put too much of a drag on the total return of their portfolio.

Retirees and IRAs

Taxes may be the last thing on your mind as you approach retirement. After all, your income will likely be lower than while you were working, right? Not necessarily. If you're retiring with significant assets in IRA's, or in company retirement plans that will be rolled over into IRA's upon retirement, the "required minimum distribution" rules that kick in at age 70 1/2 can create surprising tax issues, often pushing retirees into higher tax brackets than they expect. But there are creative ways to prepare for this.

One such way is to take advantage of a key distinction between Traditional IRAs and Roth IRAs: with a Roth, there are no mandatory minimum distributions to be taken at any point. The trick then is to convert your Traditional (including rollover) IRAs into Roth IRAs. To do so, the idea of using a money-market account to stockpile living expenses comes in handy again.

This time, as you prepare to retire, you would load the MMA with enough money to cover all living expenses for several years. By not selling any investments these first few years of retirement, and ideally delaying the start of your Social Security payments, your taxable income should be extremely low. You can take advantage of this low income by converting large chunks of your Traditional IRA into a Roth. You'll have to pay income tax on the converted amounts, but you'll be paying tax at the lowest rates.

Remember, this is tax you would otherwise have to pay later when withdrawing the funds from the Traditional IRA anyway, so you're not losing anything by paying it earlier. (Depending on the size of your retirement portfolio, both spousal work histories, tax issues, etc., delaying Social Security benefits until age 70 may be the best choice. When to start receiving benefits is a complicated decision. See Maximizing Your Social Security Benefits.)

What you gain is substantial. For starters, the money that is now in the Roth IRA will grow tax-free as opposed to merely tax-deferred. In addition, your required minimum distributions from any remaining Traditional IRAs will be much smaller when they eventually kick in, meaning lower tax and greater flexibility. And finally, if you've delayed receiving Social Security during this process, your monthly benefit will be larger. Naturally this process is going to require some planning and fine-tuning. For many people preparing to retire, paying a qualified CPA or financial planner to help with some basic planning is smart.

Summary

A financially secure retirement does not just happen. Like all worthy goals, it takes planning and managing. If you are not retired yet, a planning weekend to discuss what you would like your retirement to look like and what you need to do now to prepare for that kind of retirement lifestyle may be in order. If you are a few years into retirement, ask yourself, "What worries me most about my retirement situation?" If one of the concerns is losing purchasing power, begin to rethink your investment asset-allocation decisions and, especially if you are in your late 50s or early 60s, think about making equities a significant portion of your retirement portfolio. Proper planning and investing are an important part of making your retirement years golden.