Make a plan for the long haul

Now is the perfect time to reassess your retirement investment strategy based on your age and goals

Last reviewed: May 2009
Mom and son at a computer, dad on a cell phone, and daughter sitting at table

With the stock market losing 56 percent of its value in just 18 months, you might be wondering whether it's wise to invest in stocks for your retirement. Indeed, the Investment Company Institute, a trade group for the mutual-fund industry, says that retirement assets lost $2.1 trillion in the year ending Sept. 30, 2008. And that was before much of the real carnage started.

Many of our parents and their parents never faced the question of how to invest their retirement savings. Dad and/or Mom might have had a secure pension, so they probably didn't have to worry about the stock market. But pensions are fading away. Today's workers are among the first to be forced not only to decide how much money to put away but also where to invest it.

Nor is "retirement-savings management" likely to be something you learned in school. With little financial education, the typical American worker must now make decisions that would have been left to a licensed professional just a few decades ago. Is it any wonder we are saving too little and often picking the wrong investments?

Not that the pros are infallible either. The Congressional Budget Office estimated in October that private pension funds had lost 15 percent of their value over the previous year, and even government pension plans showed signs of potentially being underfunded. But when it comes to retirement plans in which the worker controls the investment, the picture was worse. The Urban Institute found that 401(k)s and IRAs fell 40 percent in value from September 2007 to March 2009.

Stocks don't seem like a good idea when your 401(k) statement only reminds you that you could have had one heck of a vacation if you hadn't bothered chasing employers' matching contributions or IRA tax deductions. But it remains more of a risk not to put at least some of your retirement money in the stock market. Stocks are pieces of ownership of a company, and compared with bonds (which are loans to a company), they have greater potential for growth. Of course, they also carry greater risk. But over time the returns on stocks tend to even out remarkably and easily surpass those of bonds, despite the latter's greater stability.

Wharton economist Jeremy Siegel looked at all the possible stock-market returns for the two centuries ending in 2001. He found that stocks are very volatile, but only in the short term. In any one year, their returns have varied from 66 percent gains to 38.6 percent losses. But if you invested in stocks for five years at any time in the previous 200 years, the possible outcomes would have narrowed from a 26.7 percent annualized gain to an 11 percent loss.

The longer the time frame, Seigel found, the more sense stocks make. Over any 30 years, stocks always made money. It might have been as little as 2.6 percent annually or as much as 10.6 percent. But that was generally better than bonds, which gained only up to 7.4 percent in their best 30-year period and lost 2 percent in their worst.

Probably the biggest tragedy in this financial crisis is that some people in or near retirement saw a substantial chunk of their life savings vanish as the stock market sank. Of course, people at that stage of life shouldn't have the bulk of their savings in stocks. As you get closer to retirement, it's smart to move a greater portion of your assets into more stable investments, such as bond mutual funds, money-market funds, or life-cycle funds (sometimes called target-date retirement funds), which automatically shift assets to less risky types of investments over time.

The second-biggest tragedy involves all of the young people now terrified of stocks—just as many of their counterparts were after the Great Depression. That fear is understandable, says Zac Bissonnette, who writes for AOL Money & Finance and the Daily Beast Web site. "No matter what the statistics say about usual stock-market returns, this generation has never had them," he observes. "If I'm 20 or 30, that hasn't been my experience."

What this all means is that many people are investing in a way that is exactly the opposite of what they should be doing. Some young people are being too timid, and some older folks too bold. According to the Employee Benefit Research Institute (EBRI), from January to March of this year, 401(k) retirement accounts owned by 25- to 35-year-olds lost only 4 to 5 percent, but those owned by 55- to 64-year-old workers lost between 6 and 11 percent. In other words, many young people who should have their money in risky assets are trying to play it safe. And many of those near retirement might be taking more chances than they should.

Too many investors also move their money around based on their emotions and what they predict the stock market is going to do in the short term. As a result, they often end up buying after the market has gone up and selling after it has taken a tumble. By studying when money flows in and out of mutual funds, Dalbar, a financial-research firm in Boston, has shown that investors' best intentions often end up backfiring. In 2008 the S&P 500 lost a staggering 37.7 percent. Employing all kinds of hunches, schemes, and tips, the average stock fund investor managed to do even worse, losing 41.6 percent.

But there is hope. Dalbar found that one type of investor beat the average investor by more than 90 percent by using the familiar investing strategy called dollar-cost averaging. Here's how it works: You put the same amount in your retirement account each month no matter what. That way if the Dow is very low, at, say, 7,000, you'll end up with twice as many shares as when it's very high, like 14,000. The slow and steady investor will usually beat everyone, but even that can take some nerve in times like these.

Of course, there is no cookie-cutter formula for retirement investing. How you should invest your 401(k) or IRA money depends on, among other things, how close you are to retirement, as the next three sections explain.

Live long and prosper, but try not to underestimate your likely longevity

With average life expectancy in the U.S. inching ever upward, you might be in for a longer retirement than you anticipated when you signed up for your first IRA. According to recent data from the National Center for Health Statistics, the average 65-year-old man has 17.2 more years ahead of him (for a life expectancy of 82.2 years); the average woman that age can expect 20 more years (bringing her to 85). What's more, as people grow older, their average life expectancy increases. So, for example, the average 75-year-old man has a life expectancy of 85.8 years, and the average woman at that age is looking at 87.8 years. At age 85, the average life expectancy is 91.2 for him and 92.4 for her. A lot depends, of course, on your health and heredity. If your family is full of vigorous 90-year-olds and centenarians, you might exceed those national averages—and need to save more.