Retiring in 10 Years? Uh-Oh.

By KAREN DAMATO

Imagine this scenario: You're only five or 10 years from when you hope to retire—but your portfolio looks like it needs another lifetime to bulk up.

What do you do?

Christine Fahlund, a senior financial planner at T. Rowe Price explains to WSJ's Karen Damato her unusual advice for investors heading into retirement: Save less but work longer.

Many people, of course, don't need to imagine it. It's their reality—the result of watching their investments get clobbered in the two bear markets of the past decade. And many others will face this sad state in the years ahead.

If you're one of those people, the first step is to take a deep breath and remind yourself that you're far from alone. Misery does love company.

Next, consider two messages that financial pros say people need to hear before any more time elapses:

No. 1: If your nest egg is far smaller than you will need in order to comfortably leave the work force, investment returns alone are unlikely to bail you out. You need to get serious about trimming your spending to save more money, or resign yourself to working more years.

No. 2: When your nest egg is small and time is short, you can make things worse for yourself by being either too conservative or too aggressive.

Many pre-retirees hew to one extreme or the other. When Fidelity Investments recently studied participants in the 401(k) plans it oversees, it found that 28% of participants age 55 or older either had no money in stocks or 100% of their 401(k) balances in stocks. (The no-stock folks were slightly more numerous than the all-stock crowd, 15% to 13%.)

Here's a closer look at the challenges for pre-retirees and their options.

No Time for Compounding

One way to estimate the lump sum you'll need for retirement is to rough out how much money you'll need to pull from your portfolio annually when you retire—and multiply by the painfully large number of 25. That's based on the rule of thumb that you can probably withdraw 4% of your account value in year one and adjust that by inflation each year. (That assumes you're investing in a mix of stocks and bonds and want your money to last for 30 years.)

Replacing Income

See how savings, withdrawals and equity holdings intersect.

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If you're nowhere near that target now, making changes to your asset mix—typically by adding stocks—isn't as powerful a tool as it was when you were younger. It's simple math: There aren't many years for compounding to do its magic before you start pulling money out.

Moreover, while stocks are typically the driving force in a long-term portfolio, due to their higher average returns over time, they are also a wild card. Pre-retirees face a catch-up conundrum: They could sure use the payoff from being heavily invested in stocks when the market is in a strong upswing. But they can't afford the risk of having their already skimpy nest eggs decimated shortly before or after they leave the work force.

Loading up on stocks "radically expands the range of outcomes you may experience," says Christopher Jones, chief investment officer at Financial Engines Inc., Palo Alto, Calif., which provides advice and investment management to retirement-plan participants. And in the worst cases, "what was an uncomfortable situation can go to really uncomfortable."

Finding a Balance

What that means for how you invest is this: If you have very little in stocks—say, because you fled equities amid the financial crisis of 2008—you can boost your expected return by adding some stocks to the mix. And by doing so, advisers say you'll probably be able to increase the cash you can safely withdraw. Even 20% of assets in stocks may make a difference.

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Scott Baldwin

Just don't go so far that you are setting yourself up to bail out the next time the market plunges. While taking more investment risk might make sense mathematically, "you don't magically become more risk-tolerant just because you have to," says Rande Spiegelman, vice president of financial planning at Charles Schwab Corp.

But if you've already got a lot in stocks, increasing that bet further could backfire—making your returns so unpredictable that it actually reduces the amount of money you can safely withdraw from your portfolio.

Particularly risky are big bets on individual securities, including your own company's shares. But about a quarter of 401(k) participants age 60 and older have more than 20% of their 401(k) money in employer stock, according to Financial Engines. These workers "mistake familiarity for safety," says Mr. Jones, who warns that most individual stocks "have two to three times the risk of a more broadly diversified equity portfolio."

Modeling the Future

Many financial firms use "Monte Carlo" simulations in which they look at thousands of possible patterns of market performance and evaluate the probabilities of different investment results.

Using that type of analysis, Mr. Spiegelman of Charles Schwab advises that people within three to five years of retirement should have no more than 60% of their assets in stocks and preferably closer to 40%. By Schwab's math, stock exposure at just 20% of the portfolio can work, too, if you're willing to start off withdrawals at 3.8%, not 4%, of your nest egg.

In all three cases, if you maintain that portfolio mix through retirement, Schwab has calculated that you've got a 90% probability of your money lasting 30 years.

But Mr. Spiegelman cautions that the guidelines about how much you can pull out in retirement are all ballpark figures "based on a best guess using reasonable assumptions." He says people in retirement should stay flexible about adjusting their withdrawals to actual market conditions.

Christine Fahlund, a senior financial planner at T. Rowe Price Group, concurs that "the sweet spot" for stock exposure is usually between 40% and 60% as people approach and enter retirement. At 10% or less in stocks, "you don't have the upside growth potential," she says. And if you have 80% or more in stocks, "you have so much volatility that to maintain [a high] likelihood of not running out of money, you can't withdraw as much."

Other Answers

Some other financial firms and advisers come up with very different suggested portfolios for cash-strapped pre-retirees, by approaching the issues of portfolio risk from a different angle.

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Some professional investors design portfolios so that raising and lowering stock exposure isn't the primary way to adjust risk and potential returns. For instance, in its target-date funds, Invesco Ltd. aims to spread the risk fairly evenly among three asset types—stocks, commodities and bonds—because they tend to perform differently in different economic environments. It uses derivatives contracts to add more volatility and potential return to the relatively sedate fixed-income class.

Another school of thought is that investors who are behind the eight ball would be foolhardy to do anything but invest very conservatively.

"Focusing on probability of success misleads people by ignoring the severity of failure," says Zvi Bodie, a finance professor at Boston University. He generally advises retirement savers to limit stock holdings and to rely heavily on Treasury inflation-protected securities, or TIPS, and Series I inflation-indexed savings bonds to lock in a minimum level of income that will keep up with rising consumer prices.

Advisor Software Inc., a Lafayette, Calif.-based seller of financial-planning software to financial advisers, also emphasizes a safety-first approach. For a pre-retiree who is coming up short, the company might suggest a portfolio of as much as 85% to 90% in bonds—with much of that in TIPS—and only 10% to 15% in stocks, says company President Neal Ringquist. If you can't afford to lose what you've got now, "then it simply doesn't make sense to put these assets at risk," he says.

Ms. Damato is a news editor for The Wall Street Journal, based in South Brunswick, N.J. Email her at karen.damato@wsj.com.