Where to Cast Your Net Today

New tax laws and an improving stock market make smart retirement planning even more crucial

At last, a ray of sunshine. The four-month-old recovery in stock prices is beginning to heat up returns on 401(k)s and other retirement accounts. Those brave enough to open their statements are getting a pleasant shock: Stocks rewarded them with a positive return in the second quarter, only their fourth quarterly gain since March, 2000. Signs are everywhere that this time, the warming trend could last. Retirement plans are still suffering a lot of damage -- but savers can finally see some reason to make repairs.

So there couldn't be a better time for BusinessWeek's Annual Retirement Guide. In the pages that follow, you'll learn more about the new realities of retirement planning after the bear market. You'll also find the advice you need to reevaluate your retirement plans and prepare for the coming upswing: How to recast your 401(k) to get the best returns with the least risk, how to tap the hidden wealth in your house, and how to build a human-capital portfolio of skills that can extend your earning power and enrich your later years more than any stock or bond ever could.

It's not just Wall Street's recovery that's lifting retirement wannabes out of their three-year funk. Savers are gaining important new tools to help them prepare for -- and reach -- their golden-year goals. Software developers are offering ever-improved programs for projecting your financial needs. Advisers are tuning up new products to make your retirement dollars go further -- such as improved annuities, insurance contracts that guarantee income for the longer life span today's workers can reasonably expect.

CAPITOL ASSISTANCE. Washington, too, is helping. This year's tax cut frees up cash for your retirement stash and makes investing more attractive, with lower taxes on capital gains and corporate dividends. "Nobody expected the tax cuts to be this large -- and retroactive to the start of the year," says Paula Hogan of Hogan Financial Management, a Milwaukee planning firm. "It's a great opportunity to save." And long-awaited legislation that could help 401(k) savers get more advice for their accounts is increasingly likely to pass.

But all these tools are useless unless you're prepared to act. Dan Moisand of Spraker, Fitzgerald, Tamayo & Moisand, wealth managers in Melbourne, Fla., tells his clients: "We've all suffered the shell shock. Let's move on and talk about the future." Here's how to get rolling:

-- Assess where you are. Before he talks about retirement accounts, financial planner Marc Freedman insists his clients prepare or update their net worth statement. Soaring home prices help ease the pain of 30%-plus declines in 401(k) balances. "When you look at total wealth, people haven't lost as much in the past three years as they think they have," says Freedman, president of Freedman Financial Associates in Peabody, Mass.

If you're like most 401(k) participants, Wall Street's storms haven't driven you to take cover: 63% of 401(k) contributions are flowing into stocks and equity funds in 2003, down only slightly from last year's 68%, according to 401(k) manager Hewitt Associates. That cost you during the bear market: An investor who went to cash at the market peak in March, 2000, would be 49% ahead of a stock investor now, according to Ibbotson Associates. But such market-timing generally only works in hindsight, because research shows that missing peaks or troughs by just weeks or even days can deplete a would-be timer's returns. And stock loyalists are far better positioned for the upswing: Since March, their accounts are up 18.5%, Ibbotson says, while cash has only gained 1.9% (including contributions).

-- Determine where you're going. Have your retirement goals changed in the past three years? The bursting of the tech bubble, the recession, and the events of September 11 have inspired many Americans to rethink what they want from their lives. Most baby boomers are planning to keep working, part-time or in a second career, after they've formally retired. They fret that a life of leisure will only make them grow old sooner. Earned income, even at a scaled-down job, can stretch a retirement portfolio by years, adding security to cope with today's longer life spans.

Fifty-five-year-olds in the home stretch of their career will have an easier time envisioning retirement than 35-year-olds just hitting their stride. But even a younger saver needs a plan to figure out what to save. You can start with the new rules of thumb calculated by fund and annuity manager TIAA-CREF. For instance, if you have 15 years to go before retirement, you should have already banked 2.5 times your annual salary if you're assuming assets will grow at 8% a year. If you expect just 6% growth, you should have accumulated 3.5 times your salary.

-- Clean up. Chances are, the slide in stocks and boom in bonds has reduced the proportion of stocks in your portfolio below your target level. So it's time to rebalance: Sell some bonds and buy more equities.

In your taxable accounts -- outside of your 401(k) or individual retirement account -- look for tax savings among stocks that are worth less than you paid for them. If you sell the shares while they're down, the losses can be used to offset profits and avoid taxes on other investments. Beware of the Internal Revenue Service's "wash sale" rules: You can't deduct losses if you buy and sell the same security within 30 days. To avoid that, buy more shares of the stock at least 31 days before you plan to sell, or buy a similar stock after you sell.

-- Be realistic. The NASDAQ Composite Index has been climbing steadily only since March -- but already "many people are returning to unrealistic expectations," says Harold Evensky of money managers Evensky, Brown & Katz in Coral Gables, Fla. "They think we're back to happy days again."

The sad truth: The hefty stock and bond returns investors have enjoyed since 1982 were once-in-a-lifetime rewards for the Federal Reserve's taming of inflation and Corporate America's structural makeover. Those victories drove up stock prices 2.5 times as fast as the growth in corporate earnings -- an escalation not likely to be repeated. Roger Ibbotson, chairman of Chicago researchers Ibbotson Associates, calculates that stocks will return only 8.5% in dividends and capital gains over the next decade -- a mere 5.5% after inflation -- down from the 10.2% average compounded return since 1926.

If he's right -- and a host of financial experts agree with Ibbotson's reasoning, if not his exact figures -- you'll need to save sooner, save more, and save smarter to finance the kind of comfortable retirement you want.

-- Save more. The recently passed tax cut can help. A family of four with $110,000 in income and typical deductions can expect to net an extra $1,470 this year -- $800 in a check from Treasury for an increase in the child tax credit, $335 from smaller tax payments withheld from second-half paychecks, and another $335 in a larger tax refund next spring. President Bush hopes you'll spend that cash to help revive the economy -- but you'd be smarter to divert the funds into a 401(k) or IRA before they ever hit your checkbook.

-- Place your funds carefully. The tax cut also creates new incentives for saving by slashing the top tax rate on stock profits to 15% -- down from 20% for long-term capital gains and as high as 38.6% for corporate dividends. You should still concentrate first on filling up your 401(k): You pay no taxes on the first $12,000 in annual income ($14,000 for workers 50 and older) that you put in your 401(k) this year. In addition, your employer may match some portion of your savings.

If you're an avid saver who exceeds those limits, you'll get more flexibility, and probably pay less tax over your lifetime if you put the excess in a taxable account. You'll pay the low 15% stock-profit rate each year, rather than ordinary-income rates of up to 35% when you withdraw funds.

The new lineup: Use your 401(k) for money funds and bonds that you intend to hold to maturity (interest is taxed as ordinary income). If your 401(k) allows active trading, save space there for stocks and mutual funds that you plan to hold for less than a year (short-term capital gains are still taxed at higher rates). Use your taxable account for high-dividend stocks and securities that you plan to hold for at least a year.

-- Cut investment costs. In a world of smaller stock returns and low interest rates, investment costs -- fees, commissions, taxes -- matter more than ever (table). That strengthens the case for indexing -- buying mutual funds or exchange-traded funds (ETFs) that aim to mimic a particular slice of the stock market. With little management and trading, index funds are low-cost and tax-efficient -- and just as rewarding over the long run as the typical actively managed fund.

In the stock portion of accounts he manages, Evensky has adopted what he calls a "core and satellite" approach. The core -- 80% of the account's equity allocation -- is invested in three or four low-cost index funds that cover the broad market, value stocks, and international equities. With the remaining 20%, "we take extra risks to try to beat the market," Evensky says.

His current mix: microcap stocks, emerging-market stocks, and a fund that short-sells 30-year Treasury bonds to profit from rising long-term interest rates. The stability of the core holds down fees, taxes, and risk, while the satellite gives Evensky the freedom to seek an extra kick.

-- Recognize risks. The bear market has taught investors that stocks don't always go up -- and can go down for long periods. But there's another risk that retirees can't experience first-hand until it's too late: Longevity risk, or the chance of outliving their savings. For a couple age 65 today, there's a 37% chance that at least one spouse will celebrate a 95th birthday. "The first generation of 401(k) savers, which has already taken on unprecedented responsibility to manage their own retirement, now has to figure out how to make their funds last 25 or 30 years," says Ron Danilson, vice-president for retirement and investor services at Des Moines-based Principal Financial Group.

A $1 million mutual-fund portfolio earning 7.3% has an one-in-seven chance of leaving you broke within 30 years if you withdraw $40,000 in the first year and increase your payouts with inflation, according to Ibbotson Associates (table). With a $50,000 first-year withdrawal, you have a one-in-three chance of having no money in 30 years.

To handle this risk, financial advisers are turning to an old tool: Immediate annuities, insurance policies that convert an up-front premium into a guaranteed stream of payments for life. These aren't variable annuities, heavily promoted as a tool for deferring taxes on savings; the new tax cut will render those expensive vehicles less attractive. Instead, planners are focusing on annuities' payouts during retirement as a means of insuring against living too long. Even with today's low rates, a 65-year-old couple with $1 million could purchase a fixed annuity that would pay them $59,700 a year for the rest of their lives. If they want inflation protection, they could elect a first-year payout of $44,300 that would increase each year with the cost of living.

Many retirees resist buying annuities because the insurance doesn't leave anything for heirs. "People focus on the chances that they'll die before they get all their money back, rather than on the risk that they'll outlive their money without an annuity," says John Ameriks, senior research fellow at the TIAA-CREF Institute. Insurers are responding with new products that offer a payout for heirs (albeit at the expense of the retiree's income). Principal Financial offers a rollover IRA that gradually converts from funds to annuities, providing flexible spending during a retiree's active years and guaranteed income later.

Eventually, this emphasis on annuities should ease the savings burden on workers. Instead of every couple having to save enough to cover the chance they'll need income for 30 years, annuities will pool savings to cover the most long-lived. But research on blending annuities into retirement portfolios is still in its infancy, and estimates of their impact on the need to save are scarce. "I wouldn't tell people to cut back on their savings," warns Danilson.

Indeed, if you're waiting for someone to tell you to save less, you're in for a disappointment. The bear claws of the last three years should have ripped up any illusion that catching the brass ring would be easy. But with the market turning up, Washington pulling out the stops to help savers, and new products catering to a baby boom charging toward retirement, you can at least look forward -- and get back on your plan -- with renewed optimism.

By Mike McNamee

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