The end goal for most investors is achieving a successful and satisfying retirement. The most important work we do is helping people reach that goal. In an article that’s been published on FundAdvice.com for several years, Paul Merriman distills all he has learned into 10 steps that investors can take to make their “golden” years as good as possible.

Step 1: Determine what investment return you need
This is extremely basic and extremely important, for it helps determine how you will live and what choices are available to you.

Only you can do this. You can get help from your advisors and your family members, but the final decisions rest with you. This is about determining your essential needs, the things that you simply won’t or can’t compromise.
 
Trust me on this: if you achieve higher returns than you plan for, you will be able to cope with the unexpected.

The general process for this step is simple. Figure out your essential living costs per month – the amount below which you simply cannot make it. Your definition of this will be uniquely your own.

Some people are unwilling to consider reducing their standards for housing, entertainment and other expenses, no matter what. Others know they can be happy while they lead extremely frugal lives. We know a man of quite modest resources who doesn’t have a car, lives in a tiny condominium, rarely buys new clothes or furniture and almost never eats in a restaurant. Once a year he uses his savings to take a three-week trip – he’s going to New York and London this summer.

Whatever it takes, determine the rock-bottom monthly income that’s necessary to sustain you. Then tote up your other resources such as a pension, Social Security and any other income you can count on. There will probably be a gap between this income and your monthly needs. That’s the amount that must come from your investments.

If your essential needs can be met with $5,000 a month and you have reliable income that totals $3,500, the gap would be $1,500 a month, or $18,000 a year.

With that information, you can figure out the rate of return you must have. If your investments are worth $600,000, that means you can meet your essential needs with a return of 3 percent – a figure that suggests you’ll have some breathing room. But if your assets total only $200,000, taking out $18,000 every year won’t work for very long. You’ll know right away from that calculation that you must either acquire more assets, find a source of additional income or cut your essential living standard.

This first step can be discouraging. But it’s essential because it will force you to face up to reality – ideally while you still have options available to you.

Step 2: Determine the investment return that you desire

This is an easier step. Again, it will come from a monthly-income calculation.

If you’ve done the first step properly, you eliminated some non-essential expenses in order to reduce your needs. Now it’s time to add some of them back in. Think of this as a list of optional (but highly desirable) accessories to your life: Travel, gifts, entertainment, home improvement, education … this list has no limits.

Your goal is to arrive at a figure that, if you added it to your base monthly income, would make your life much better, giving you a future worth looking forward to. This is not the place to fantasize about winning the lottery. This is a place to be realistic while you still dare to dream big dreams.

Suppose you determine that an extra $3,000 a month would make a huge difference. That suggests another $36,000 a year from your investments. You can do the math and figure out whether that is feasible.

A good rule of thumb is that you can conservatively count on withdrawing 5 percent of your portfolio every year. If you invest that portfolio well, you can keep doing that with a high probability that your portfolio’s value – and thus your annual “draw” – will gradually rise over time without much risk of running out of money.

The flip side of that rule of thumb is that you can know you have enough to retire if your investments are worth 20 times the annual income you desire from those investments.

To continue the example we cited above, if you have $600,000 in your portfolio and you need it to provide you with $4,500 a month instead of $1,500, it won’t take long to figure out that you can’t get there from here. A monthly draw of $4,500 means $54,000 a year, which is 9 percent of $600,000. No portfolio can reliably sustain that level of withdrawals for very long.

This is very useful information to have before you commit yourself to retiring on an $8,000-a-month budget. Your choices then become clear: Work longer to let your assets build up, or scale back your expectations. Or both.

The rule of 20 cited above suggests that you should have a portfolio worth $1.08 million before you count on taking out $4,500 every month.

Common sense suggests that you can probably compromise somewhere between taking $1,500 and $4,500 out of your portfolio every month. When you reach this point, you can begin to see the tradeoffs that reality imposes.

For example, if you work three years longer before retiring, how much more could you add to your retirement pool? And how much extra retirement income would that give you?

Alternatively, if you scaled back your retirement income by $1,000 a month, how much earlier could you retire?

These are important questions new retirees – and those contemplating retirement – need to wrestle with.

Step 3: Determine your tolerance for risk

This step is crucial, and it’s overlooked by most of the investment advisory industry. The reason is not hard to find: The investment business is by-and-large a sales culture, and thinking about risk doesn’t put people in the mood to invest their money – any more than focusing on serious traffic accidents puts people in the mood to buy new cars and trucks.
The investment sales industry likes to focus on returns. Advertisements show happy people, not scared people. Too many people think investing is about making money. But investing is really about taking risks and then managing them. That’s what investors get paid to do.

Smart investors figure out how much they are willing to lose and invest accordingly. This can be a tricky process, and we spend quite a bit of time on it when we meet with clients.

Most retirees invest in stock funds and bond funds. And for most of them, the basic way to control risk is by increasing or decreasing the percentage allocated toward bonds. More bonds means lower risks (and generally lower returns as well). More stock funds means higher risks (and generally higher returns).

I’ll give you a tool in Step Six to help you apply this principle to your own situation.

These first three steps are the most important ones in our 10-point plan. But even when you have completed them to the best of your ability, you are far from finished if you want to maximize your ability to enjoy your retirement.

Step 4: Base your decisions on what’s probable, not what’s possible

Here’s a true story that cites an extreme case: Richard Buck, our publications manager, was formerly a business reporter at the Seattle Times, where one of his specialties was local banks. He remembers that a blue-collar worker at the newspaper once asked him what was the safest bank in Seattle. This worker confided that he and some friends were “investing heavily” in the lottery; they wanted to be sure in advance that they had a safe place picked out for their money.

This worker, who as far as we know never won any part of a jackpot, was focusing on what was (just barely) possible, not what was probable. All his nervous planning, in the end, was wasted.

In the late 1990s, investors became accustomed to equity returns that regularly topped 20 percent. Some asked us for advice on how to achieve regular returns of 40 to 50 percent, and many were indignant when we refused to take such questions seriously.

It’s fine to hope for the best, which today might mean a string of low-double-digit returns. But many analysts believe upper-single-digit returns are much more probable over the next decade.

In the 1990s, many investors made another significant mistake: They concluded they could be comfortable and rich all at once, by investing in the Standard & Poor's 500 Index, which is filled with familiar, successful companies. That mistake became apparent in the first few years after the turn of the century, when many S&P 500 Index companies led the nosedive in stock prices.

It of course was theoretically possible that large-cap U.S. growth companies would continue to be the best performers. But history suggested that wasn’t highly probable.

From 1926 through 1994, the S&P 500 Index was the worst performer of the major asset classes we recommend, with an annualized return of 10.2 percent. From 1995 through 1999, the annualized return was 28.6 percent.

Too many investors forgot caution – after all, this was a “new era” for investors, according to many analysts. Cheered on by Wall Street firms hoping to attract more assets to manage, too many investors were too quick to dismiss the lessons of history. When the “experts” told them what they wanted to hear, who were they to argue? Many of them thought they were being conservative when they projected steady future returns of “only” 15 to 18 percent.

The S&P 500 Index’s 28.6 percent return over a five-year period did not mark a change in the long-term trend. The return for 1926-1999 was 11.3 percent. But reality came home to roost in 2000, 2001 and 2002, when the index’s three-year annualized return was minus 14.5 percent.

After those three wrenching years, the 1926-2002 annualized return of the index was 10.2 percent – exactly the same as from 1926 through 1994. In case you’re wondering, the 1995-2002 annualized return was 10.3 percent.

This is called regression to the mean, the tendency of statistics to return to long-term averages. It doesn’t always happen. But it’s highly likely.

In planning your retirement, you’ll always be better off to use conservative assumptions rather than optimistic ones.

I hope you’ll trust me on this point: If you do better than you plan for, you’ll be able to cope with your unexpected higher returns. But if you plan optimistically and the future fails to measure up to your plans, you could find yourself facing some mighty unpleasant choices.

Step 5: Determine what assets have the highest probability of giving you the returns you need

This means you should own much more than just large-cap U.S. stocks, which are represented by the Standard & Poor's 500 Index.

Here’s a simple example. Remember that from 1926 through 1994, the S&P 500 Index had an annualized return of 10.2 percent. During that same period, U.S. micro-cap stocks returned 12.6 percent, small-cap value stocks returned 14.6 percent and large-cap value stocks returned 12.4 percent. An average of those four asset classes could have gained 12.5 percent, much higher than the S&P 500 Index alone.

From 1995 through 1999, the S&P 500 Index led the pack with its gains of 28.6 percent. The average of all four was 21.5 percent –a terrific gain for any five-year period. In 2000 through 2002, when the S&P 500 Index lost 14.4 percent a year, the four-way combination lost only 1.7 percent a year.

If you diversify among asset classes that have performed well over very long periods, you won’t get snookered into putting all your trust in whatever has been performing well lately.

Step 6: Determine what combination of assets will produce the return you need within your risk tolerance

You may want the expected returns that come with an all-equity portfolio. But such a mix of assets is too risky for most retired people. Remember the general rule that the higher the return you seek, the more risk goes with it.

There are three steps in this process.

First, find the best combination of equity assets. For information on exactly how to do that, see an article that’s easily accessible on our Web site called “The Ultimate Buy and Hold Strategy.” That article will also help you take the second step, which is to identify the best fixed-income assets to stabilize your portfolio.  Third, find the right percentage combination of equity assets and fixed-income assets to give you the best balance of return and risk.

Here’s a case where you can make the best decision when you have the best information.

In our workshops, we use a table that shows several historical risk measures for portfolios split between stocks and bonds in various percentages. There’s an example of this table on our Web site in an article called “Fine Tuning Your Asset Allocation.”

The most important numbers in those tables are in the rows at the bottom. They show the annual returns as well as six measures of risk for every combination. This is the kind of information that investors should focus on when they ask themselves how much risk they can (or how much they want to) take on.

One interesting way to use this table is to fold it so that only the bottom six rows are visible. Then scan across whatever line seems most relevant to your concern (for instance the worst 12-month period) and find the closest column to the right (indicating higher risks and higher returns) that would be acceptable to you.

Then make sure the other risk measures in that column would be acceptable to you. If not, keep going to the left until you find the first column in which every one of those measurements of risk would be acceptable.

Assuming you are a buy-and-hold investor, that tells you the percentages of your portfolio that you should have in bond funds and equity funds. That will tell you the past return that such a combination would have produced. But the return figures are less reliable in the future than the risk measures.

Our advice: Give priority to the risk measurements, not past returns.

Step 7: Keep your expenses as low as possible

If you think of an investment portfolio as a sailboat trying to move forward, then think of expenses as an anchor being dragged behind. They slow you down. You may have a wonderful sail and a great crew. But you won’t get where you want to go very efficiently if you are dragging a heavy anchor behind you.

There are two kinds of expenses: ongoing and one-time-only. Almost all investments involve some type of recurring expenses. Savvy investors always want to know what the expense ratio is. Naïve investors ignore this, focusing instead on marketing hype and recent returns.

Investors should expect to pay for investment management and the administration that goes with it. But they don’t have to overpay. One of the least expensive ways to invest is in index funds. Vanguard’s 500 Index Fund (VFINX), which follows the Standard & Poor's 500 Index, is a bargain, charging its shareholders just 0.18 percent per year in expenses. But some funds charge more than 1 percent a year to invest in essentially the same group of stocks. That’s counterproductive and unnecessary.

Expenses in actively managed funds, which depend on stock-picking, vary widely, though they are almost always higher than in index funds. For an example, we looked at the “analyst picks” of Morningstar Inc. among small-cap value funds. These five funds are the favorites in that category among professionals who spend all their time studying mutual funds.

Morningstar says the average annual expense ratio in this category of funds is 1.32 percent. The analyst picks charge expenses that range from a high of 1.45 percent in the Gabelli Small Cap Growth Fund (GABSX) to a low of 0.84 percent in FPA Capital (FPPTX) Fund.

The difference, 0.48 percent, can be pretty significant. On a $10,000 investment held for 10 years and assuming two identical underlying portfolios, that difference could easily cost an investor $1,200. That amounts to 12 percent of the original investment. It’s not a sum that most investors would voluntarily give up if they were offered the choice.

Yet investors routinely ignore expense ratios, considering the numbers too small to bother with. Most Wall Street firms have little incentive to turn investors – their customers – into penny pinchers. On the contrary, they thrive when investors pay little attention to such details.

There’s another reason why expenses make a difference that’s worth paying attention to. To see this factor, I’d like to have you temporarily take the point of view of a fund manager, not an investor.

Imagine that you and your brother are starting two mutual funds. He gets to make the decisions about one fund and you make the decisions about the other.

Your brother believes investors will pay whatever he asks, so he sets his expense ratio high, say 1.6 percent a year. You, on the other hand, know you can cover your expenses and make a good living charging only 0.9 percent a year. The two of you may do joint marketing and wind up competing with each other – after all your offerings are part of a common fund family.

You both know that performance is what sells, and that performance figures are stated after expenses. That means that even if the two of you invest in the exact same portfolio, your brother’s fund will inevitably have a lower return than yours.

If the common portfolio’s underlying return (before expenses) is 13 percent, your brother’s fund will have a reported return of 11.4 percent (13 minus his expense ratio). Your fund will sport a return of 12.1 percent (13 minus your expense ratio).

In competition, you are going to have a much easier time attracting investments. To keep all the money from going to you, your brother must either reduce his expenses or increase his underlying return. Being the competitive, ambitious guy he is, he may scoff at the first approach and work on the second.

To achieve a return equal to yours, he must have a portfolio that earns 13.7 percent. In fact, he would most likely shoot for an underlying return greater than 14 percent in order to effectively compete with you.

And how would he go about this? By being more aggressive and taking more risks.

Here’s a little formula that Wall Street doesn’t want you to know: Higher expenses mean either less return or more risk. This is true in general for almost every investment you can make. If you pay higher expenses, you will either get lower expected returns or take more risk – and often it’s both.

The second kind of expenses to watch out for are one-time expenses. Some you can’t avoid, like the $10 and $15 annual fees that mutual funds and brokerage houses charge on IRAs. But sales commissions can usually be avoided.

We preach the gospel of no-load funds. A sales load of 5.75 percent on a mutual fund can take a whopping amount out of your pocket on the first day of your investment. That money doesn’t go to the manager as an incentive to do a better job for you. The money goes to support a sales organization.

Go back for a moment to the example of two funds run by you and your brother. Imagine your brother decides to drop his expense ratio to match yours. But, always looking for ways to make more money, he decides to charge a 3 percent load to all new investors.

Here’s what that means to an investor with $10,000: In your no-load fund, $10,000 goes to work immediately under your management. In your brother’s load fund, only $9,700 can be invested.

If you and your brother invest in identical stocks that have a return of 12.1 percent after expenses, in one year your fund will turn $10,000 into $11,210. In your brother’s fund, the same portfolio will turn $9,700 into only $10,874.

In order to generate $11,210 at the end of one year, your brother’s fund must gain 15.6 percent. The only way to have a decent shot at getting that return is to invest in a riskier portfolio. The result: In return for paying a sales load, investors in this fund have bought the prospect of either lower returns or higher risk.

Buying a load fund, or paying a commission up front on any product, is like betting on a horse that must start the race from somewhere behind the starting line. A terrific horse might be able to overcome that handicap. But do you want to bet on it? Remember Step 4: Count on what’s probable, not what’s possible.

Step 8: Minimize your taxes

There are lots of ways to do this, and anybody’s tax situation can have many components. So it’s hard to give blanket advice that will apply to every taxpayer in every case. This is a big topic, worthy of a long article by itself.

Here are some general points:

• Understand the difference between ordinary income and capital gains. You’ll pay more tax on the former, less on the latter. Also, pay attention to the difference between long-term gains (from holding an investment for a year or more) and short-term gains (holding periods less than one year).

• Understand the difference between taxable accounts, tax-deferred accounts and tax-free accounts. Taxable accounts give no shelter from taxes, and every transaction is potentially a “taxable event.” In a tax-deferred account such as a 401(k) or a traditional IRA, you pay no taxes until you withdraw the money – but everything that comes out of the account is taxed at ordinary income rates, and you get no benefit from the lower capital gains taxes. In a tax-free account such as a Roth IRA, you pay taxes on income before it goes into the account, but all your contributions and earnings are tax-free when they are withdrawn.

• Pay attention to upcoming capital gains and income distributions before you invest in a mutual fund, especially late in the calendar year. If your timing is wrong, you could wind up being taxed on part of the money you invest as if it were a profit. This is not fair, but it’s the way things work.

• Choose tax-efficient mutual funds. A study by Lipper found that U.S. mutual fund investors paid approximately $8.6 billion in taxes in 2002. The study found that over the previous 10 years, taxes paid by mutual fund shareholders on average amounted to almost 1.8 percentage points of return on equity funds and almost 1.5 percentage points of return on fixed-income funds. Portfolio turnover is one good indicator of tax efficiency. When other things are equal, the fund that has lower portfolio turnover will leave more money in your pocket. You can also compare funds’ tax-adjusted returns, which are reported by Morningstar Inc.

• Don’t double up on tax shelters. It makes no sense to buy a variable annuity inside an IRA. Don’t take advice from any planner or broker who tries to put tax-deferred assets into your IRA.

• Keep records of your mutual fund purchases and reinvestments of dividends and capital gains. If you are sloppy, you can wind up eventually paying taxes twice on the same income.

Step 9: Put the management of your portfolio on automatic

This is the best way to keep your emotions from subverting your intentions and your plans.

Economists who study human behavior say people make financial decisions based on their emotions. Yet the outcomes of those decisions are not determined by emotions. The outcomes are determined by hard, cold reality. I believe this difference is one of the biggest challenges facing investors.

If you’re still accumulating money, sign up for automatic investment plans whenever you can. That way, you’ll know the money goes to work for you when it should. Dollar-cost-averaging will make sure you automatically buy more shares when prices are lower and fewer shares when prices are higher.

Index funds will make sure you automatically diversify and adjust your portfolio for the comings and goings of various companies.

If you are using a timing system, hire somebody to do it for you. That way you know for sure that the timing system you have chosen will be followed.

Putting your portfolio on automatic is also the way to give yourself the highest probability of success and to defend yourself against sales pitches from brokers who want you to do something different.

Step 10: Determine the best strategy for withdrawing your money

This can be tricky, and you may benefit from sitting down with a professional to make sure you understand the decisions you must make and their ramifications.

One of the most important decisions you face is whether to take out a fixed amount from your investments every year or whether to let your withdrawal vary from year to year depending on the performance of your investments.

This is essentially a choice of what type of risk you want to take. If you take a fixed amount from your portfolio, you will know what you can count on and plan your life accordingly. But you take the risk that you could run out of money because your withdrawals won’t have anything to do with your investment performance.

If on the other hand you take a variable amount, say 5 percent or 6 percent of the portfolio value each year, you can be pretty sure you won’t ever run out of money, and you’ll most likely have some left over to leave in your will. Consequently, you’ll know that the amount you withdraw is an amount you can afford. On the other hand, with this plan you won’t know what you can count on for living expenses in the future.

You also must figure out a way to make withdrawals that will keep your portfolio properly balanced in the assets that in turn will keep you within your risk tolerance.

It’s very important that you take this final step with plenty of thought, so you can learn from the mistakes and successes of those who have gone before you. For a more thorough discussion of this topic, see an article on our Web site called “Retirement: When Your Portfolio Starts Paying You.”

This completes the list of 10 steps I cover in my workshops. They will steer you in the right directions and steer you away from the biggest sources of financial trouble.

But no description of the “perfect retirement” would be complete if it focused only on financial factors. Here are a few other things you can – and should – do in order to make sure you get the most benefit from this important part of your life.

Make sure you have plenty to live for. A good exercise is to write a list of at least 100 things you want to do: places to go, people to see, books to read, golf courses to master. Make sure you know what will get you motivated each morning. Then give yourself ways to pursue those things.

Take care of your health by seeing your doctor regularly and taking his or her advice. Don’t neglect your mental health, either. It’s a major determinant of how satisfied you’ll be in retirement.

Keep yourself mentally active and challenged. You’ll live longer – and you’ll want to live longer. Read. Write. Take a course. Teach a course. Travel. And when you travel, don’t always go on group tours where everything has been arranged ahead of time. Choose stimulating destinations and travel in ways that will require you to figure things out.

Cultivate new relationships. Don’t make the mistake of crawling into a shell. Meet people who share your interests, including people who are younger than you. The happiest retired people I know have lots of favorite people in their lives.

As I wrote in an article for Alaska Airlines Magazine a few years ago: At the end, life can sweep away our dignity and our money. But if we have friends with whom we can share joy, pain and respect, we are blessed.
 

Paul Merriman is the founder and educator at Merriman.