Shrinking nest eggs: How the ailing economy affects yours

— -- Patty Stewart of Redlands, Calif., is beginning to think she won't be able to retire at 65. Or 67. Or possibly ever.

Like millions of other people, Stewart is counting on her 401(k) and her home equity to pay for retirement. But since the start of the year, the value of her 401(k) has fallen about 4%, and rising consumer prices have forced her to reduce her contributions to it. Meantime, home prices in her neighborhood are off about 25% over the past two years, making it less likely she can rely on her home equity to supplement her retirement income.

"The calculators tell me I'm going to need $1.3 million to $1.5 million" for retirement, says Stewart, 49. "That doesn't seem like it's something that will ever happen."

She might be right. For years, stock investors have been led to expect average annual returns of 8% to 10%. Similarly, many people have assumed that their homes would appreciate by roughly 10% a year.

Both assumptions, though, rest on two decades of outsize returns — returns that were inflated by low interest rates that fueled bubbles in the values of stocks and real estate. Now, many financial analysts are predicting a prolonged period of below-average returns on both stocks and home equity.

If they're right, Americans need to face a sobering fact: They're not likely to have as much money for retirement as they'd projected. Which means that many of us will have to save more, expect less and work longer than we'd planned.

Investors who rely on historical returns for the past 50 years will "probably overestimate what we're likely to see in the future," says Chris Jones, chief investment officer for Financial Engines, a retirement-plan consultant.

"As much as we'd like to say history is a good guide to what the future holds, it's simply not true."

Consider a 45-year-old with $100,000 in savings and income of $50,000 this year.

If that worker contributed 8% of income to his 401(k) plan for 20 years, received an annual raise of 4% and earned an average return of 10%, he'd retire at 65 with $878,862.

By contrast, if his average investment return were only 8%, he'd end up with much less — about $652,000. And if he earned an average return of only 6%, he'd retire with just $486,310.

Greg Womack of Womack Investment Advisers in Edmond, Okla., says overly rosy projections represent one of the biggest pitfalls in retirement planning.

"Any time you look forward and do forecasting," he says, "it's better to do it on a more conservative basis."

That means factoring in an above-average rate of inflation and a below-average rate of return on your investments. "If things turn out better," Womack says, "you're ahead of the game."

Many financial planners say they believe workers who start saving while they're young will still be able to meet their retirement goals.

The reality, though, is that many Americans are already far behind in saving for retirement.

Nearly half of American workers have less than $25,000 in retirement savings, according to the Employee Benefit Research Institute. Thirty-six percent of workers 55 and older have less than $25,000 in savings.

Downturn could look like the 1970s

Some economists believe the economy is headed for a period that will more closely resemble the bearish 1970s than the vibrant 1980s and '90s. And for investors, the '70s were quite bleak.

From Dec. 31, 1969, through Dec. 31, 1979, the Dow Jones industrial average gained a grand total of just 38.38 points, or 4.8%.

During the 1972-1973 bear market, the Dow fell 45.1% over 482 trading days. From 1966 through 1982, not counting dividends, the Dow's performance was essentially flat.

Already, the economic slowdown is causing Americans to rethink their retirement plans. More than one-quarter of workers ages 45-64 say they've postponed plans for retirement because of the sputtering economy, according to a new survey by the AARP.

Dick Alexander, 60, of Rome, Wis., had planned to retire at the end of this year from his job as a comptroller for a manufacturing plant.

Now, however, he plans to wait until at least the end of 2009. Because of the recent declines in the stock and real estate markets, he wants to postpone when he needs to start pulling money out of his retirement savings.

And yet, Alexander is better off than most of his peers.

He and his wife have been contributing to retirement savings for many years, and he'll also receive a pension. Even so, he's concerned about soaring health care costs and the outlook for his retirement savings.

"If you (earn) 6% or 7%, things are wonderful — you'll be able to leave an endowment," Alexander says. "If you earn 3% or 4%, then you get to some point in time when you run out of money."

What's weighing down returns

Of course, pessimists have been wrong in the past. Through the years, the U.S. economy has proved remarkably resilient. But analysts who are now convinced that investors need to lower their expectations for stock returns point to these headwinds:

•Inflation. Most retirement calculators assume an annual inflation rate of about 3%. But that figure reflects two decades of below-average inflation.

Since 1960, the average inflation rate has been higher — about 4.3%. And some not-so-distant periods have seen raging inflation. From 1970 through 1980, for instance, the average annual inflation rate was 8.2%.

With demand for food, energy and health care surging around the world, savers, investors and retirees should plan on higher inflation for years to come, says H.K. "Bud" Hebeler, publisher of AnalyzeNow.com, a retirement-planning website.

Investors stand to suffer because higher inflation tends to damage stocks, in part because rising consumer prices trigger higher interest rates. And higher rates, in turn, can weaken corporations and the overall economy.

Higher inflation hurts savers, too. It forces them either to put aside more money or to try to earn more on their investments to stay ahead.

The outlook is even worse for retirees. That's because they spend a disproportionate share of their income on items that tend to rise faster than overall inflation: food, energy and health care.

•Taxes. Wall Street analysts — and lots of folks on Main Street, too — argue that the widening federal budget deficit, combined with rising demands on the Social Security and Medicare programs, will force the next presidential administration to raise taxes.

If higher taxes lead to lower stock prices, as is often the case, investors would earn less. Retirees, meanwhile, would pay higher taxes on their withdrawals, reducing their after-tax income.

Martin Martlock, 60, of Commerce Township, Mich., says his concerns about higher taxes and inflation have led him to reassess his retirement plans. Martlock, who hopes to retire at 62 from his position at a company that helps administer workers' compensation, is also better off than most.

When he retires, he'll receive a pension, which he thinks will cover his living expenses. But he's counting on his savings to pay for his health care costs — savings that he now fears will be taxed at higher rates.

"I think there's going to be some increase in the income tax in general," Martlock says. Given the rising deficit, he says, "I don't see how they can avoid that.

"I also have concerns about how expensive health care may become," he adds.

"If you're uncertain about the expenses you face, it makes you a little apprehensive about making a change in your financial circumstances."

A house is just a home

During the height of the recent housing boom, Americans saw their homes appreciate much faster than the mutual funds in their 401(k) accounts.

That led many to assume they'd naturally be able to supplement their retirement savings by selling their homes, downsizing and pocketing the difference.

And among those who don't want to move, some have assumed that a reverse mortgage would provide extra income if needed. (A reverse mortgage is a loan against home equity that doesn't need to be repaid until the borrower moves, sells the home or dies.)

A 2005 study by the National Council on Aging estimated that reverse mortgages could help more than 13 million Americans pay for long-term care.

But the collapse of the housing market has wiped out billions of dollars in home equity.

Nearly 9 million homeowners are "upside down," which means they owe more on their mortgages than their homes are worth, according to Moody's Economy.com.

Those people and many others with little home equity may find that a reverse mortgage won't be there to bail them out.

Since the housing boom peaked in 2006, average home prices nationwide have fallen more than 15%. Robert Shiller, the Yale economist who correctly predicted the end of the tech-stock and real estate bubbles, says he thinks home prices could fall much more before the market turns around, even exceeding the 30% decline that occurred during the Great Depression.

Mark Joseph, a financial planner in Reston, Va., says the housing downturn may force people to face the reality that a home isn't a reliable source of retirement income.

Joseph, along with other planners interviewed, says he never includes a client's home in calculating the individual's retirement assets.

The fact is, Joseph says, most people don't want to leave their homes when they retire.

And those who do move often end up spending more money on their "downsized" home than they did on the home they sold, he says.

Inflation makes it harder to save

Yet if homes are taken out of the equation, that means Americans will need to rely even more on their 401(k) accounts and other investments to pay for retirement.

And the factors that are weighing on their investment returns — inflation and a sluggish economy — are the very factors that make it harder for workers to save more.

Patty Stewart, who works in information technology for a health care company, began saving for retirement only about 10 years ago, because her previous employers didn't offer a 401(k) plan.

She began saving aggressively, putting away 20% of her salary, and has about $125,000 in her account. However, rising prices on everything from gas to earthquake insurance have forced her to cut her contributions to 10% of her pay.

Stewart says she and her husband, who works in commercial construction, have good jobs.

But given the shaky economy, they want to take no chances. Their mortgage lender recently froze their home-equity line of credit, so they no longer can count on home equity as a source of emergency funds.

Now they're focusing on paying off their auto loans and other debts as fast as possible.

Once they've paid off that debt, "Hopefully we'll be back to putting more in our 401(k)s," Stewart says. "If we have some boom years, the 401(k) will come back.

"Right now, it's a little scary."