Retirement Saving In The Home Stretch

In the final installment of The Early Show's three part series on retirement, financial contributor Ray Martin had advice on how to maximize your 401(k) when you are close to retirement.

The typical advice given is that today's retirees typically need an amount of retirement income that is at least 70 to 80 percent of their pre-retirement income.

How well are you doing? Take this simple test. Add up the value of your 401(k), IRAs and other savings earmarked for your retirement. You can also add to that sum the amount of home equity you will free up from the sale of real estate. When you get a final number, assume you will be able to draw five percent of this sum each year in retirement. So, if you'll have $200,000, you should be able to draw $10,000 from your retirement savings each year.

You also need to factor in that your retirement savings must last 20 to 30 years. That's how long a healthy 65-year-old is likely to live.

The problem is that the median 401(k) plan balance for workers aged 55 to 64 was $60,000 in 2004. By the measure above, such a balance would only provide about $3,000 a year of income in retirement, or only about $250 a month.

When it comes to managing a 401(k) plan account, workers nearing retirement need to think about their 401(k) plan differently than younger and mid-career workers. There are three areas that workers nearing retirement should get up to speed on: maximizing contributions, diversifying investment mix and planning for withdrawals.

401(k) contributions — maximize contributions and catch-up

Workers nearing retirement have only a few more years to make pre-tax contributions in their 401(k) plan. That's because after they leave their employer, they will no longer be able to contribute to their 401(k) plan account from payroll. Workers over age 50 can make total pre-tax contributions of $20,000 ($15,000 pre-tax contributions plus $5,000 catch-up contributions) to their 401(k) in 2006. But many workers do not do this.Percent of 401(k) plan participants making maximum contributions:

Annual Income:

$60,000 to $80,000: 8.3 percent
$80,000 to $100,000: 18.8 percent

Given that this is the last opportunity to increase the account and make pre-tax contributions, more near-retirement workers should be contributing more.

Also, employees who are faced with a freeze in future pension benefits (which are affecting a lot of workers at larger employers) need to save more to offset the lack of additional pension benefits. How much more you will need to save will depend on a number of factors, including the number of years you are from retirement. Below is a table of additional savings amounts workers affected by pension cuts may need to save:

Your age and the extra amount you will need to save:

50: 13 percent
55: 16 percent
60: 19 percent

Source: Employee Benefits Research Institute

Some older workers, particularly those who earn $100,000 or more, are often prohibited by their plan's rules from contributing more than 7 percent of their pre-tax pay into their 401(k) plan because of regulations that prohibit highly compensated employees from contributing disproportionately more than non-highly compensated employees. If this happens to you and you are over age 50, make certain that you are also making CUCs as these are excluded from these rules.

Diversify your allocation in pre-retirement years

Workers nearing retirement typically have larger retirement account balances and thus investment diversification and protection from downside risk are paramount concerns. Because workers nearing retirement they have less than 15 years from beginning to take withdrawals and their account balances are larger, having a greater portion of their investment mix in stable value and bond funds is appropriate.

But according to a recent report, 32 percent of 401k participants held no stock funds, 21 percent held almost all stock funds and participants in 401k plans of larger employers held over 33 percent of their 401k plan accounts in company stock.

Failure to properly diversify can result in unrecoverable losses for workers nearing retirement because they lack the time to make contributions for a long number of years in the future. But they also need to consider that they will leave some of this money invested for another 20 to 30 years, so having some allocation to stocks funds, which have a better chance of producing returns in excess of inflation, is also prudent.

Investment mix for people in their 50s and 60s

Stable Value/Bond Funds: 55 percent
Large Co Stock Funds: 25 percent
Mid Co Stock Funds: 5 percent
Small Co Stock Funds: 5 percent
Foreign Stock Funds: 10 percentWhy to stay in your 401(k) instead of rolling over into an IRA

Workers nearing retirement, who have saved a substantial amount in their company's 401(k) plan should strongly consider leaving their money in the company retirement plan, before deciding to roll over to an IRA, according to Martin.

The Financial Research Corp. of Boston found that an estimated $2.3 trillion will be rolled over from employer retirement plans into IRAs from 2003 to 2010. For many more future retirees, their retirement savings will be the cornerstone of their financial security, as pensions and Social Security make up a much smaller portion of the retirement income they will need to get by.

A litany of advertisements from brokerage and mutual fund companies target a growing market of individuals who will consider transferring or rolling over their retirement nest egg to an IRA.

But Martin says retiring employees need to know that the 401(k) plan provided by their employer provides several advantages and their employer has a fiduciary obligation to serve the best interests of the plan and its participants, instead of serving the interests of a particular financial firm, which is selling its own IRA products.

Also, larger employer plans have powerful bargaining leverage over investment managers and service providers, and use their size to negotiate institutional pricing for investment management at low rates.

For example, it's not uncommon for a large plan to offer an S&P 500 index fund with total annual investment expenses of less than 0.08 percent, as compared to the average expenses of a similar retail index mutual fund which can carry fees of over seven times more, and also have possible front-end or back-end charges of over three percent.

Advantages of leaving your retirement assets in a 401(k) plan

Lower investment expenses

According to the Department of Labor Study of 401(k) Plan Fees and Expenses, investment management fees for investment funds offered in employer 401(k) plans range from .35 percent to 1.01 percent, which is a bargain when compared to the range of .59 percent to 1.95 percent for investment expenses in IRAs. All things being equal, over time, lower fees means that your retirement savings will last longer in a lower cost 401k plan versus being invested in higher cost funds in an IRA.

Low account fees

Employer retirement plans do not charge low balance fees and annual account costs can range between $25 to $35 per year. Most IRAs require a minimum balance and most charge account fees that range from $35 to $50 per year. Unlike retail brokerage IRAs, typically there are no transaction fees for buying and selling funds in most employers' 401(k) retirement plans.

Unique investment options

Many employer plans offer a stable value or guaranteed fund option, which provides an investment option with a high degree of safety and a reasonable current return. For example, a retirement plan provided by Boeing offers a stable value fund with a current yield of 4.64 percent.

These types of funds are an increasingly larger part of a retiree's asset allocation as preservation and predictability of returns become more important. Stable value or guaranteed funds are NOT available as mutual funds in brokerage account IRAs and it's hard to find a conservative investment with a yield even remotely close to this current rate in a retail IRA.

Other investment options uniquely being offered to 401(k) plan participants include the ability to use a part of a 401(k) plan account to buy an immediate annuity at low cost, or institutional prices. This allows a retiree who remains in their 401(k) plan to buy a monthly income stream, or convert part of their 401(k) plan balance into a monthly pension at a rate that pays more monthly income than what is available from products available from retail IRA offerings.
Flexible withdrawal features

Many employers' plans allow participants to take withdrawals from their plan in periodic installments to be taken from specific investments. The combination of periodic installments taken from a stable value fund or a partial withdrawal to buy an immediate annuity can be a good option for retirees to draw-down their account over an extended period of time.

But retirees need to check to see if their 401k plan allows a non-spouse beneficiary to remain in the plan — in some plans, after a retiree dies, the beneficiary who is not a spouse must receive the remaining plan account balance as a taxable distribution.

You should also know that after you retire, you can still leave your balance in your 401(k) plan and you have to begin taking required minimum distributions by the year after you reach age 70.5 — which can be a long time away for today's workers nearing retirement. If you are still employed at age 70.5, then you do not have to take any required minimum distributions until after you retire.

Plan, Plan, Plan

List your current annual expenses and cross off those that will disappear when you retire. Maybe the mortgage will be paid, for example, and the kids are out of college. Still, many expenses will be the same. Government data show that people over 65 spend roughly the same percentages of their yearly income on housing, transportation, food and entertainment as do all Americans.

Estimate your new expenses in retirement. One big change: higher health-care costs. People over 65 spend more than twice as much on medical care as the average American, even though they're insured by Medicare. Why? Well, Medicare beneficiaries still have annual deductibles and co-insurance payments. Also, there are costs that Medicare may not cover-such as nursing-home care.

Plus, health-care inflation is huge. In 1985, retirees 65 or older spent on average $880 on medical care, including premiums and out-of-pocket costs, says Roland McDevitt, director of health research at Watson Wyatt Worldwide. In 2005, they spent $5,150 — a 485 percent increase.

Finally, a sobering statistic is that on average Americans spend about 80 percent of their lifetime costs paid for health care during the last third of their life.

How much to withdraw

To make sure your money lasts as long as you do, experts say, you can't afford to withdraw more than 4 percent to 5 percent of your life savings every year, adjusted annually for the rise in the cost of living. Say you have a $500,000 nest egg. To be reasonably sure that it lasts 30 years, you must limit your withdrawals to an inflation-adjusted $25,000 a year.

"Inflation-adjusted" means you boost your withdrawal each year to match the previous year's inflation rate. If you withdraw $25,000 in your first year of retirement, and the inflation rate that year is 3 percent, the next year you'd withdraw $25,750 ($25,000 plus 3 percent, or $750). If inflation that year is 2 percent, your third annual withdrawal is $26,265 ($25,750 plus 2 percent, or $515.)

Where should you withdraw from first?

You should also think about the order in which you withdraw money from your different accounts. Generally, a good tip is to start taking money from your regular taxable accounts first and let your tax-deferred accounts grow as long as possible. So dip into your 401(k) last because all withdrawals will be taxable as income and could also cause more of your Social Security retirement benefits to become taxable as well.

Social security benefits

Find your estimated Social Security benefit. The government mails this to you each year. (Go to www.ssa.gov for more information.) Let's say you can expect $11,500 a year. Add your pension, if you're lucky enough to have one. Let's say its $5,000 a year. Your total Social Security and pension income is thus $16,500.