On the Home Stretch to Your Retirement

EDITOR'S NOTE: This article was originally published in the February 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

Workers approaching retirement are focused on the finish line. They anticipate sleeping late, taking exotic trips or spending more time with family. But as they sprint toward those goals, many overlook a formidable obstacle: a yawning gap in their savings.

With the demise of defined-benefit pension plans, tumultuous markets, skyrocketing health care costs and a bleak employment landscape, the last few legs of the race to retirement have become much tougher than they used to be. Many people are running out of steam as they hit the home stretch. Nearly half of people age 57 to 63 in 2010 won't have enough retirement income to cover basic expenses, according to the Employee Benefit Research Institute.

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What's more, some popular strategies for catching up on retirement savings may backfire on older workers. Many people are investing more aggressively in hopes that higher returns will close a savings gap. But that raises the risk that a market downturn will trip them up just as they enter retirement. And though baby boomers are increasingly banking on working longer, research shows that nearly half of recent retirees left the workforce earlier than anticipated. To assume that you can simply keep working if you don't have enough saved at retirement age is "extraordinarily risky," says Jack VanDerhei, research director at EBRI. "It may not be feasible."

The good news: It's still possible to close a significant savings shortfall, even if you're within a few years of your planned retirement date. While you may not be able to count on a surging stock market or steady employment, there are powerful factors within your control that can propel you into a secure retirement. These include maximizing the tax-efficiency of your portfolio, optimizing Social Security benefits, reviewing your asset allocation, and of course, saving more and spending less.

To close a savings shortfall, the key is "taking concrete steps, even if those are relatively modest steps," says Christopher Jones, chief investment officer of 401(k) advice provider Financial Engines. Here's how to ensure that your final working years will set you on course for a smooth retirement.

Mind the savings gap. If you fear you're losing the retirement-savings race, your first step is to determine the size of your savings gap. Older workers tackling this task hear a bewildering array of retirement-saving rules of thumb. Some advisers say retirees need their investments, Social Security and other income sources to generate about 75% of their preretirement income, while others say that figure is closer to 100% or more.

Instead of searching for the perfect formula, consider simply tracking your expenses for a couple of months. Separate essential outlays from discretionary expenses, bearing in mind that retirees typically want to maintain the lifestyle of their working years. If you eat out once a week and have season tickets to the symphony, plan on doing the same in retirement.

An online budgeting tool such as Mint.com can help you categorize expenses and weed out those, such as commuting costs, that won’t continue in your retirement years. To determine whether your portfolio, pension and other benefits will cover those expenses, run your nest-egg numbers through a free retirement-income calculator, such as T. Rowe Price's tool at www.troweprice.com/ric.

To be sure, there are a host of uncertainties in such back-of-the-envelope calculations. You may face massive long-term-care expenses or move to a lower-cost city. But at least the exercise will give you an early warning sign if you're facing a savings shortfall. "It would be unrealistic to think whatever budget you come up with for the next few years will be the same one you'll have 10, 15 or 20 years from now," says Christine Fahlund, senior financial planner at T. Rowe Price. "But at least you can get started."

If you have a large savings gap, remember that even those getting a very late start can build substantial nest eggs. Consider a 55-year-old who earns $80,000 a year and has no retirement savings. If she maxes out her 401(k) in each of the next ten years, including the $5,500 catch-up contribution for participants 50 or older, and receives a 3% employer match, she could have roughly $426,000 saved at age 65, assuming a 7% annual return, according to T. Rowe Price.

As with losing weight, the task of boosting savings will look a lot more achievable if you "look at it in small increments rather than the end goal," says Maria Bruno, senior investment analyst at the Vanguard Group. So instead of making an unrealistic vow to max out your 401(k) on day one, consider some budget cuts. If you have high-interest credit card debt, for example, start paying it down and putting the money you would have spent on interest into retirement savings. Also review the fees on your 401(k) investment options, which can take a big bite out of your nest egg over the long term. If your plan offers only high-cost funds, consider contributing just enough to get your employer's full matching contribution, and then put additional savings into low-fee funds in an IRA.

Those playing catch-up might also consider downsizing to a smaller home. "A bigger house means not only a bigger house payment but more maintenance bills," says Carrie Schwab-Pomerantz, senior vice-president at Charles Schwab. Downsizing, she says, is "an easy way to really reduce your expenses."

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Thanks to a natural human tendency to procrastinate, it's also useful to make a commitment to boost your savings rate on future dates, says Financial Engines' Jones. If you're saving $500 a month now, he suggests, set a reminder on your smartphone to boost savings to $600 next quarter. Some 401(k) plans also offer programs allowing participants to automatically ratchet up contributions. It's like making a dental appointment, Jones says. "You wouldn't be excited about locking yourself into it tomorrow," he says, "but making one a year from now feels a lot less scary."

Don't roll the investment dice. It's tempting to amp up investment risk in hopes that higher returns will close a savings gap. To see the perils of such a strategy, look no further than the financial crisis. Nearly one-fourth of 401(k) participants age 56 to 65 had over 90% of their account balance in stocks at the end of 2007 -- setting themselves up for devastating losses during the market downturn, according to EBRI.

An investor's savings rate can be more effective in boosting wealth than aiming for higher returns, according to a recent Vanguard study. A worker who starts saving at age 45, when he is earning about $64,000, and socks away 15% of salary in a moderate 50% stock, 50% bond portfolio, would wind up with a median portfolio balance of nearly $320,000, according to Vanguard. That's much more than the $289,000 the worker would achieve if he saved a bit less -- only 12% of salary -- but opted for a more aggressive 80% stock, 20% bond portfolio. "You can pick an asset allocation, but the day-to-day volatility of the markets you can't control," says Vanguard's Bruno.

To make your portfolio last through 30 or more years of retirement -- and keep up with inflation -- a broadly diversified 40% to 60% stock allocation is reasonable for workers within ten years of retirement, advisers say. Spread stock holdings among U.S. and international, large and small companies to help protect against market downturns.

Dial down risk as you approach retirement. About five years before you leave the workforce, for example, you might focus on building a bucket of the safest bond holdings that will cover your first five years' worth of retirement expenses. You should also have at least one year's worth of living expenses in cash.

Gradually shifting assets toward fixed-income holdings allows you to establish a "floor" under your retirement income, says Financial Engines' Jones. And that income floor won't collapse if stocks tank. Financial Engines' Income+ service, which offers management for 401(k) accounts, each year shifts some of investors' stock holdings into bond funds, which are used to provide steady payouts from 65 to 85. A separate bucket of bond holdings is set aside so that investors have the option of purchasing an annuity at 85.

Aim to work longer. Workers are increasingly counting on longer careers to help bolster their retirement savings. In 2010, 7% of the working population age 50 or older planned to retire at age 75, up from 4.3% in 2006, according to EBRI.

Indeed, working longer can be an effective tool for rescuing a floundering retirement. While you continue to work, you keep contributing to your retirement plan rather than tapping into savings. Meanwhile, tax-deferred balances have more years to grow, and your nest egg needs to sustain you for fewer retirement years.

Yet many people planning to work longer may be disappointed. Fully 45% of retirees in 2011 left the workforce earlier than planned, often because of health problems or corporate downsizing, EBRI found. While working longer can be a nice bonus for people who need to catch up on savings, "people should always treat that as Plan B," says EBRI's VanDerhei.

Instead of counting on an employer to keep you working later in life, entrepreneurial near-retirees might consider starting a side business while still employed, advisers say. That way, "you can have something up and running, something you can retire into," says Michael Reese, owner of Centennial Wealth Advisory, in Traverse City, Mich., who notes that a number of his clients are looking at this option. "A little bit of income can go a long way toward plugging the gaps."

A late-career transformation from employee to small-business owner helped resuscitate retirement savings for Donna McCullough, 67, of Columbia, S.C. She had no retirement savings in her late forties, when she started working as an auditor for a corporation. Over six years of working at the company, she contributed only 3% to 6% of her salary to a 401(k) -- until her job was downsized.

At 54, McCullough started her own business, helping attorneys prepare for audits. Every year since, she has socked away 15% of income in a SEP IRA, a retirement plan for the self-employed. She also carefully monitors expenses, generally spending no more than $1,500 a month. Now McCullough feels she has plenty of savings to maintain her lifestyle, do some traveling and stay on course for a secure retirement -- if she ever retires, that is. Though she doesn't want to work more than 20 hours a week, "full retirement never even crossed my mind," McCullough says. "I love to work."

Maximize Social Security. Another clear advantage of working longer is that it allows near-retirees to delay taking Social Security benefits. Those born in 1943 through 1954 can delay Social Security beyond full retirement age of 66 and get an 8% increase in benefits each year up to age 70. That's a guaranteed return that's tough to find in any safe investment product. If you claim at 62, your benefit will be reduced permanently by 25%.

Delaying Social Security can also be a more effective way to address a savings shortfall than buying an annuity, according to the U.S. Government Accountability Office. A hypothetical 62-year-old male looking to generate $16,000 in income at age 66, for example, could take Social Security benefits of $12,000 annually at 62 and at 66 buy an inflation-adjusted annuity for $71,000 to provide the remaining $4,000 annually. But if he instead delayed taking Social Security until age 66, he'd receive $16,000 in annual benefits, and he'd sacrifice just $48,000 in benefits in the years between 62 and 66 -- far less than the cost of the annuity, according to the GAO.

For single people, delaying Social Security generally makes sense if you expect to live beyond 80, says William Reichenstein, a Baylor University investment professor and principal at Social Security Solutions, a firm that helps people optimize their benefits.

For married couples, the higher earner generally should not claim benefits until 70, says T. Rowe Price's Fahlund. The lower earner could claim early. She'll bring extra cash into the household, and then she can step up to her spouse's survivor benefit when he dies.

Make the tax code work for you. Some of the most powerful ways to stretch a retirement portfolio are hidden in the tax code. By drawing down your nest egg tax-efficiently in retirement, you can make a portfolio last up to seven years longer, says Reichenstein.

To maximize your options for making tax-efficient withdrawals, you need to save in both taxable and tax-deferred accounts during your working years. Consider a married couple over 65 drawing money from savings to cover expenses. While the conventional wisdom would be for them to draw money from taxable accounts, leaving 401(k) money more time to grow tax-deferred, that's probably not the best solution, Reichenstein says. This couple could take enough money from the 401(k) to fully use a low tax bracket, such as the 10% rate applied to married couples' taxable income up to $17,400. Add that to the $21,800 of income they can receive tax-free in 2012 (thanks to personal exemptions, the standard deduction and deductions for people over 65), and the couple could draw up to $39,200 from the 401(k) this year with none of the funds taxed at more than 10%.

Even if tax rates remain the same in the future, Reichenstein says, it can be beneficial to fully use the lower bracket from age 66 to 70. Once you start taking required minimum distributions from your tax-deferred account at age 70, he notes, you might be bumped into a higher bracket. "You don't want to blow the opportunity to take pretax dollars out" with a minimal tax bite, he says.