Retirement planning 101: Seven questions you need to answer

Retirement planning isn't easy. Nearly half of Americans don't feel financially prepared to live to age 75, according to a survey from Northwestern Mutual. But the process is a lot less burdensome if you break the task down into simpler parts. Here are seven questions to ask as you plan for your long-term financial security in retirement.

1.How much should you try to save for retirement?

Rita Cheng, a certified financial planner, poses for a portrait with her children Sarina Haryanto (left), Karolina Haryanto, and Christian Haryanto at their home in Potomac, Md., earlier this month. How much to save for retirement can have so many variables that families often consider consulting a financial planner. (Jacquelyn Martin/AP/File)

At the core of the typical retirement plan is the goal of building assets that will provide income, alongside Social Security and other sources, during your senior years. But how much do you need to save by age 65 or 70? And what does that mean for your present saving habits?
 
The math gets complicated fast, because there are so many variables. How much to save depends on things like your future wage growth, inflation, longevity, future spending needs, what year you hope to retire, and whether you have a defined pension in addition to Social Security.
 
Many families will find it helpful to consult a financial planner who is paid by client fees (not paid by a financial company to promote certain products). A planner would help with setting a savings target and with other steps in retirement planning.
 
But online calculators can also offer some useful guidance.
 
One free tool that blends ease-of-use with relatively sophisticated results is T. Rowe Price's retirement income calculator. Answer a few questions, and soon you'll see a chart of how much you're on track to save now, and how much you might need to boost that amount to have a 70 percent chance of hitting a prudent target by retirement. The tool lets you test what happens when you shift a few parameters (like retirement age).
 
An alternative online tool, worth noting because it's considered state-of-the-art by some finance experts, crunches the numbers to fit a theory called "consumption smoothing." This is the idea that your goal is to maximize your quality of life (the "consumption" part) over your whole lifetime (the "smoothing" part).

The service, called Economic Security Planner, often gives very different advice from the typical online calculator. And it can be tailored specifically to one's situation – such as factoring in when you'll stop helping a child through college and start putting some extra money toward your own retirement. The software concept was crafted by financial economist Laurence Kotlikoff of Boston University.
 
Whether you turn to a professional or to some software designed by professionals for guidance, don't be frozen by the complexity of the decisions. Doing something is much better in this arena than doing nothing, finance experts say. So set a goal, keep saving, and you can revise or improve your plans as you go.

What will your 'asset allocation' be?

Specialists Patrick King, left, and Christopher Carella work on the floor of the New York Stock Exchange earlier this week. Typically, younger people have a greater share of their retirement assets allocated to stocks than do older people. But some financial planners urge even seniors to remain heavily invested in stocks because of their better long-term return historically. (Richard Drew/AP)

Deciding what share of you savings to put into different types of assets – stocks, bonds, etc. – is a crucial step. It can go a long way toward determining how fast your money grows and how much financial risk you face from market gyrations.
 
The classic advice is that younger savers should put a majority of their money into stocks, generally via mutual funds, and then shift increasingly toward fixed-income investments (which are less volatile in price) as they get closer to retirement. But coming up with a plan is an individual matter that depends in part on your own tolerance for risk.

It doesn't do any good to try to follow some expert's "ideal" plan if you can't sleep at night as a result.
 
Some questionnaires on financial-company websites offer to help you find the right mix of assets. In some cases real-world events can provide a gut check that confirms – or changes – your framework.
 
Note that even finance experts differ, sometimes sharply, on the best approach. Some financial advisers have urged retirees to maintain a substantial portion of assets in stocks, with the idea that the capital gains will generally sustain a nest egg longer in today’s era of expanding longevity. A counter view, argued in a new book "Risk Less and Prosper," by economist Zvi Bodie and financial consultant Rachelle Taqqu, is that Americans have put too much faith in stocks, which can be risky even when held over long time periods.
 
Mr. Bodie advises that more emphasis be placed on inflation-protected bonds. And, when retirement comes, he says fixed annuities are an important guaranteed-income option.
 
Still, over the 80 years ending in 2006, the inflation-adjusted annual return of stocks was 7 percent annually, using the Standard & Poor's 500 index as a benchmark. Such performance can mean savings held in stocks grow much faster in general than savings in bonds (2 percent real annual return over that time period) or cash (Treasury bills posted a 0.8 percent annual return during those decades, according to the investment firm Vanguard).
 
One final asset-allocation option to mention: handing the keys to an "expert" by investing in a so-called target-date mutual fund. Vanguard, for one, reports fast-rising use of these funds, which come with a mix of stocks and bonds precooked for individuals in a specific age bracket.

What kind of stocks do you buy?

High school students participate in an event celebrating music education and kicking off the national Fidelity FutureStage music program at the Kenwood Academy in Chicago in this 2010 file photo. The event is sponsored by Fidelity Investments, whose mutual fund offerings range from low-cost index offerings to actively managed stock funds. (Fidelity Investments/AP/File)

Once you know how much of your investments you want to put into stocks versus bonds and other vehicles, the central choice on stocks may be this: How much do you emphasize breadth and simplicity (covering all bases) versus the potential rewards of a more targeted approach to picking stocks?
 
In other words, do you focus entirely on "index funds" that passively track the overall stock market (or large portions of it), or on a mix of stocks selected by professional mutual fund managers or by yourself? Many people blend these two approaches.
 
Neither strategy is perfect. Neither is likely to be a winner when the market is tanking.
 
Indexing has some big virtues. You keep costs down, because you aren't paying fees to cover a lot of managerial decisionmaking. Fidelity's Spartan Total Market Index fund has an expense ratio of just 0.7 percent annually, for example.) Also, if some of your money is in taxable accounts, you won't incur as many capital gains taxes, because these funds essentially use a "buy and hold" strategy.
 
More important, index funds give you instant diversification. For instance, you could divide your money between a single broad-based fund that tracks the whole US stock market (from large companies to small ones), one that tracks foreign markets, and perhaps boost your holdings of small- and mid-size stocks by putting a little extra in an "extended market" index fund.
 
With that strategy, if Apple is doing well, you'll own some of it. If markets in Germany or India are hot, you'll own some of their stocks, too.
 
What do actively managed funds offer? On average, they hit you with higher fees and slightly lower returns than the overall stock market. But in a given year, some actively managed funds will be stellar performers. They can also help you target your own favored approach to investing, if you have one.
 
Also, In some cases they can offer strategies to cushion the downside risk of stocks. Some stock funds actively hedge market risks, rising a bit less when the market is soaring, but avoiding a sharp fall when a downdraft arrives. Other mutual funds, such as those called long-short funds, aim to rise in price even when the overall market may be flat, by buying (going long) on expected winning companies and "selling short" some expected losers.

Which mix of bonds do you prefer?

Traders work in the 10-Year Treasury Bill Options Pit at the CME Group in Chicago in this 2010 file photo. Although bonds are traditionally less volatile than stocks, their prices do rise and fall depending on the direction of interest rates. (John Gress/Reuters/File)

Bonds and other fixed-income investments generally aren't exciting, but that's exactly the point. They're supposed to be relatively safe, providing a steady stream of income with less price volatility than stocks.
  
But be warned: Bond prices do fluctuate, and some relatively sharp swings could be on the horizon. Bond prices generally shift in relation to interest rates and to changing perceptions of the economy. The period since 1980, with a long downturn in interest rates, relatively tame inflation, and a financial crisis that scared people toward safer investments, has been good for bonds.
  
Bond prices will go down, finance experts say, when perceived economic growth or inflation strengthen enough to push interest rates higher. The trend in interest rates will determine the yield (income payments) on newly issued bonds, of course. But when interest rates change, the prices of existing bonds also shift so that their yields reflect the going rate of interest. When interest rates rise, bond prices fall and hence their yield goes up.
  
That doesn't mean bonds are riskier than stocks, which fell much harder than bonds during the financial crisis.
  
Fixed-income investments are many and varied. You can buy broad-based bond mutual funds, or narrower mutual funds that invest only in corporate bonds or only in US government bonds. Funds that invest in municipal bonds (and bonds issued by state governments) are generally exempt from federal taxes – a benefit that’s meaningful for money invested outside of a tax-sheltered retirement account.
  
US government bonds are considered to have very low risk of default, while many corporate bonds have a higher (albeit small) risk of default.
 
Some savers prefer bond mutual funds for their simplicity. Others prefer to buy a "ladder" of individual bonds with varying maturity dates. You buy new bonds as older ones mature and the principal is returned.
 
With either approach, one type of bond to consider as part of the mix is the category called "inflation protected." These, offered by the government, pay interest and shield you from the risk that the value of your principal will be eroded by inflation. One of these options called Treasury Inflation Protected Securities, and another is Series I (that's letter "i") savings bonds.
 
Check out the “Treasury Direct” program online if you want to buy bonds straight from the federal government.
 

Do you try bond alternatives?

A man uses a Bank of America ATM in Charlotte, N.C., Wednesday. Cash stowed in a bank account has the virtue of being stable and government insured (up to a point), but it offers relatively low returns that don't always keep up with inflation. (Jason E. Miczek/Reuters)

One alternative to bonds is the certificate of deposit, which pays interest on money you park for a period of your choosing, such as one or two years.
 
Here are two other important alternatives that share a fixed-income element, but are quite different from bonds: cash and annuities.
 
Cash held in a money-market fund or savings account has the virtue of price stability, at least in a manner of speaking. A dollar that you put in typically won't fluctuate in its face value – except for those very rare cases in which a money-market fund "breaks the buck" when its holdings lose value. (FDIC-insured accounts offer the greatest safety, guaranteeing your money even in cases of bank failure.)
 
But cash has the disadvantage of earning very low (sometimes barely visible) interest income.
 
That means even money market funds are risky. In the past few years, those low rates of interest have meant you earn a negative real return on your money – it's not even holding its value against inflation.
 
Note that some online banks offer much better interest rates than the typical large commercial bank.
 
As for annuities, these insurance products can offer an efficient way to lock in a fixed income in retirement. You commit to put money in up front, and the insurer agrees to pay a fixed amount each month during your retirement. One example is a New York Life product, the "Guaranteed Future Income Annuity," that workers can contribute to.

With some annuities, you can pay extra for inflation protection or survivor benefits.
 
Note: What you're reading about here is a  “fixed annuity," as opposed to the “variable" kind of annuities that are more akin to stock mutual funds (more potential upside gain, and more risk)
 
Some savers may choose to build a base level of retirement income through Social Security, fixed annuities, or other fixed-income holdings, and then turn to riskier stock investments to build their nest eggs up from there.
 
One important risk for annuities: Their guarantee is only as good as the insurance company that makes the promise. If an insurer fails, many states have reserve funds that will provide a partial payout to policyholders. So check into ratings and the reputation of the insurance company before you buy.

Any role for ETFs or individual stocks and bonds?

William Rhind and Fred Jheon of ETF Securities pose on the floor of the New York Stock Exchange in this 2010 file photo. The company offers several gold and other precious metal ETFs that make it easier to invest in metals. (Business Wire/File)

The easy option for most retirement savers is to put money in mutual funds. In turn, each mutual fund typically has holdings of stocks or bonds.
 
But mutual funds aren't your only option. There's also a close sibling called exchange-traded funds (ETFs). And there's the opportunity to buy individual investments (like shares in Google or Gillette) on your own. These options are often accessible not just in brokerage accounts but also when you're saving in a tax-sheltered IRA (Individual Retirement Arrangement).
 
ETFs are like mutual funds in many ways. You buy shares of a fund that holds a large pool of investments. Some ETFs track stock market indexes, or invest in major classes of bonds.
 
With ETFs, the "exchange traded" part is important. You can buy or sell your shares any time during the financial market's trading day, whereas mutual fund transactions typically occur at the end of the trading day, even if you placed your order in the morning or the night before.
 
But some researchers have found that ETFs have greater "tracking error" than mutual funds typically do. Tracking error is when a fund's performance deviates from the stock index that the fund aims to mimic, 

 
And consider per-transaction commissions, as well as annual management fees ("expense ratios"), when weighing the costs of ETFs vs. mutual funds.
 
If you buy individual stocks or bonds, remember not to put too many of your eggs in one basket. One of the most common mistakes, potentially tragic, arises when workers put lots of their savings in the stock of their employer. If that one stock fails to keep up with the broader market, or plunges (think Enron back in 2001), it has an outsized impact on your standard of living.

What else will you do?

Residents of John Knox Village, a continuing care retirement community in Pompano Beach, Fla., stay active with the many activities available on site – from chair yoga to woodworking in this 2010 file photo. Retirement planning is not just about how you'll save but what you'll do. (Melanie Stetson Freeman/The Christian Science Monitor/File)

Retirement planning isn't just about saving and choosing investments. Here are some of the additional steps to consider:
 
1. Follow through on your plan. Track your progress and reevaluate your goals and asset allocation every year or so. And even if your plan stays on cruise control, many financial experts recommend "rebalancing" your portfolio once a year, to make sure the mix of stocks and other asset classes remain in the blend that's right for you.

Rebalancing can act as an automatic (but only partial) cushion against market swings. If stocks are in a bubble, you'll probably be selling some before the bubble bursts.
 
2. Think about expenses. Consider your expected lifestyle and the spending it might involve. Many planners say retirees will run through about 20 percent less money than they did as workers. In part that's because expenses like commuting go down.

Still retirement may have some extra expenses, such as long-term care insurance. And your own situation may differ from the norm. You may want to travel a lot, devote resources to grandchildren, or have to factor mortgage debt into your plan.
 
In general, one rule of thumb from many advisers is to draw down your retirement sayings by no more than 4 percent per year, to ensure that your income will last. (With fixed annuities, the size of the annual income stream is built into the contract.) 
 
3. Use your employer match. If your employer's 401(k) style plan offers to match your contributions, take advantage of it. It's leaving free money on the table if you fail to contribute up to the matching limit.
 
4. Stay fit in nonfinancial ways. Making an effort to remain active can mean lower expenses and a happier life during retirement. Similarly, making efforts to maintain your "human capital" can pay dividends. Many Americans will keep working at least part-time during retirement. With that in mind, you may want to stay active in professional networks, keep your skills up to date, or maybe prepare to branch into new career directions, such as from corporate to nonprofit work.