Look Out Below! Five Threats to Your Financial Security
Lower stock returns, higher inflation, a Medicare disaster: Problems like these could screw up even the best-laid retirement plans. Here's how to reduce your risk.

(FORTUNE Magazine) – You've been maxing out your 401(k) since you began working. You piled into stocks through the raging bull market of the '80s and '90s. Your house has quintupled in value. And now you're feeling pretty darn good about how well you'll live in retirement. A little smug, even.

This story is for you. A host of financial planners and other investment pros we consulted warn that even the most diligent savers and savviest investors may face serious threats to their financial health--ones they may not have fully factored into their retirement planning. Here are five of the most significant threats, plus our advice on what you can do to counter them.

1. Lower Stock Returns It's an article of faith for most investment pros: Over the long term, stocks rise--and they rise faster than bonds or cash. Since 1926, the S&P 500 has returned an average of 10.4% a year, vs. 5.5% for bonds and 3.7% for cash, according to Ibbotson Associates. Long-term averages, though, obscure the fact that sometimes stocks stink.

Timing matters. If you started in the early '80s, terrific: During the great bull market of 1982 to 2000, stocks were rising so fast that it almost didn't matter whether you were investing enough. Appreciation made up for it. But if you started in 1999, no such luck. "What is commandingly clear," says Jim Grant, editor of the newsletter Grant's Interest Rate Observer, "is what a sweet golden moment [the early 1980s] was for financial assets." Back then, Treasury yields were around 12%, and 12-month trailing price/earnings ratios were in the single digits. Now, conditions have neatly reversed, with low yields and P/E ratios averaging 20. So for the foreseeable future, investors will probably be riding the equivalent of a horse-drawn trolley, not a bullet train. At FORTUNE's recent retirement roundtable (see page 41), the consensus expectation for stocks was just 6% a year for the next five to ten years.

Does that mean you should be pulling out of stocks? Of course not: Even at that tepid pace, they're still likely to be the best available option. But reduced returns are a compelling argument for saving more money (see "Psych Yourself to Save" for some tips). They are also an argument for paying much more attention to stock-investing costs that you can control, such as fees (by using, for example, a discount broker and low-cost mutual funds) and taxes (by buying and holding when possible rather than by rapidly trading).

2. Inflated Inflation Inflation is retirees' worst enemy, eating away at the value of their assets and their standard of living. The consumer price index rose from an annual average of 2.5% since 1991 to 3.5% in April before falling slightly. No one thinks the U.S. is about to become 1980s Argentina or Weimar Germany, where hyperinflation devastated society. But as anyone who remembers the 1970s can tell you, inflation here is quite capable of hitting the double digits. Even a small rise in inflation can have devastating effects. A monthly pension of $3,000 will buy only $2,055 worth of goods in ten years, assuming 3.5% inflation. At 4.5% inflation, that number falls to $1,849. At 5.5%, it's $1,665.

What's more, real-life inflation may be much worse than the official statistics indicate. Take a look at the CPI's methodology. Its statisticians make use of "hedonics," a method of attaching a value to the increase in the quality of new goods. Here's an example: If your new computer cost $500 more than your old one but had more than $500 worth of improvements (according to Treasury wonks), the CPI says it actually cost less. The sticker price for a car bought in the U.S. has risen 338% since 1979, according to the Leuthold Group, an economic consultancy. But because of hedonic adjustments, the CPI reflects only a 62% rise.

Another curious thing about the CPI is that it does not calculate changes in housing costs by the sales prices. Instead it uses a figure that estimates what homeowners would get if they rented out their homes. In 2004, national housing prices rose more than 11%, but the CPI calculates that they rose about 2%. Bill Gross, founder and managing director of PIMCO, an investment company that has more than $464 billion under management, estimated in late 2004 that real inflation could be a full percentage point higher than the CPI. That means, for example, that Social Security payments, which are linked to the CPI, may lag real-life expenses.

How do you cope with inflation? For one thing, don't shy away from stocks, which tend to outpace it. Treasury inflation-protected securities (TIPS) are low-risk investments that are guaranteed to keep pace with the CPI (although as we noted above, that may not reflect the true cost of living). But the most important thing you can do is to be realistic when developing a financial plan about how much money you'll need to maintain your standard of living in retirement.

3. Piddling Interest Rates In the '60s, the generation gap was about sex, drugs, and rock & roll. Today it's about interest rates. The Federal funds rate is at 3%, and ten-year T-bills are at 4.1%--not much higher than inflation. That's great for younger people buying homes and taking out loans to fix them up. It's rotten for older ones trying to live off their savings. Just a few years ago a retiree with $1 million to invest could have stashed it all in supersafe Treasury bonds and locked in an interest stream of $64,000 a year. Today that same $1 million would get you only $41,000 a year.

There are no easy ways to cope with lower rates. One remedy, mentioned above, is to sock away more money. Dividend-paying stocks also offer some relief: Many financially strong companies are yielding 3%, 4%, or more. Those payouts are taxed at a lower rate than interest on bonds, and many companies raise dividends over time, while bond payments are fixed. Also, avoid long-term bonds and stick with those that mature in just two to five years, suggests Gary Schatsky, a New York City financial planner. These days, the shorter-term bonds pay almost as much, and if rates do rise, you'll be able to swap them for new bonds with fatter yields when they mature.

4. A Medicare Disaster President Bush's big plans for Social Security have attracted all the headlines lately. But the fate of Social Security should scare retirees far less than the fate of Medicare. In terms of net present value--the amount the government would have to set aside to generate the returns necessary to pay future obligations--Medicare is running $63 trillion short. The comparable figure for Social Security is a mere $8 trillion.

That's the conclusion of recent work by Jagadeesh Gokhale, a senior fellow at the Cato Institute and former economic advisor to the Cleveland Federal Reserve, and Kent Smetters, an economist at Pennsylvania University's Wharton School of Business. Essentially, they added up all the promises the federal government has made regarding Social Security, Medicare, Medicaid, and so on; they also projected nonentitlement expenditures. Then they looked at government revenues and totted up the difference between current and future obligations and projected revenues. Taking into account surpluses in some areas, they came up with a total figure of $66 trillion. Then our dismal scientists asked what the feds would have to do to fill this hole. Answer: Raise the payroll tax for Social Security and Medicare by another 16.6 percentage points (it is 15.3% now) or the income tax by more than two-thirds. Now and forever.

Something's got to give--and that something is bound to include generous Medicare coverage. By the time today's working stiffs retire, they will almost certainly be paying more of the cost of health care themselves. So if you haven't already, start embracing a healthier lifestyle pronto. And consider Medigap insurance, which helps cover the difference between what Medicare covers and what you are responsible for paying. For more information on Medigap policies, go to AARP.org/healthcare/medicare.

5. Longer Lives A generation ago, the typical guy who got his gold watch at 65 would keel over at 78. Today, a 65-year-old man is far more likely to live to 82. His 65-year-old female counterpart is living longer too: to 85. And astonishing advances in anti-aging medicine (see "The End of Aging" on fortune.com) may soon make centenarians as common as July fireflies. That's not such great news for our retirement plans, however. The longer we live, the more money we need.

Women are at particular risk. Not only do members of the allegedly weaker sex outlive men by several years, but they are at the top of the demographic charts when it comes to reaching really, really old age: Two-thirds of the over-85 set are female. But because women tend to have more fractured work histories--they are twice as likely to work part-time, for example--and to make less money when they do work, their retirement kitties are much thinner. Young women (ages 21 to 34) are also more likely than men to carry debt--something Cindy Hounsell of the Women's Institute for a Secure Retirement (WISER) in Washington calls the "Carrie Bradshaw effect," after the Sex and the City character who belatedly realized that she could not monetize her $40,000 worth of Manolo Blahniks into a down payment on an apartment.

Then there's divorce, a phenomenon that will likely affect the baby-boomers more than any previous generation. Pension assets are considered the property of both spouses, but not every state requires that they be divided when the marriage breaks up. And of course, an ex-wife has no right to future pension benefits that accrue to her former spouse. That's if the husband has a pension at all: Traditional company-funded pensions are fast going the way of the dodo. Only a quarter of women collect pension benefits from their ex-husbands, according to WISER. "Being a woman is a retirement risk," sums up Alicia Munnell, the director of Boston College's Center for Retirement Research.

To be safer, both men and women should save and invest as though they'll live to, say, 95 rather than the 85 that many financial planners recommended as recently as a decade or two ago. And consider your family history. If your grandmother lived to 100, consider buying an annuity (see "How an Annuity Can Protect You"), an investment product whose main attraction is payments that last as long as you do.

FEEDBACK jboorstin@fortunemail.com and cmurphy@fortunemail.com