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How to Avoid Retirement Portfolio Panic

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After the stock market crash in 2008, Rich Happoldt saw the stocks in his retirement portfolio plummet 45 percent. Fortunately, he had a steady pension from Levi Strauss, along with Social Security. His stock portfolio, which still hasn't fully recovered, was the third leg in his income-generation strategy, though. Now, he's counting on his valuable Templeton, Calif., home to fund his later retirement years.

"Stuff happens," Happoldt said, who retired at 58. "What can you do? I probably shouldn't have retired so early."

Do you know if your portfolio can weather another 2008? That's an important question to ask. For starters, a 401(k) portfolio has to be diversified and not concentrated in employer stock. But that's far from enough in terms of avoiding preretirement portfolio panic.

With Americans living longer, people nearing retirement are facing some choppy waters. Current high stock prices and rock bottom bond yields are playing havoc with the future returns needed for retirement expenses. So people are forced to make tough choices to balance growth and income, financial advisors say.

(Read More: Why You May Need a Retirement Coach)

The biggest threat? Low-yielding bonds are dinging retirees' future income generating ability, according to a Morningstar study.

Forget the 4 Percent Rule

For years, financial planners have followed the time-honored 4 percent rule for plotting annual retirement withdrawals. It dictates that a portfolio allocation of 60 percent stocks and 40 percent intermediate-term Treasurys can fund 4 percent withdrawal rates over 30 years without exhausting savings.

However, Treasurys now yield only 1.66 percent, far below the historical average. The result is that annual retirement withdrawal rates are 2.8 percent—not 4 percent, according to Morningstar. This tricky combination—high stock prices and low bond yields—hasn't occurred together since the late 1930s, said David Blanchett, director of retirement research at Morningstar.

So relying on safe, traditional investments like Treasury bond funds to protect and grow money no longer works. For 30 years, Treasurys delivered annual returns of up to 8 percent, said Frank Porcelli, managing director of BlackRock's US Wealth Advisory Business. These days, playing it safe with bond funds is much more risky than investors realize, he added, especially if interest rates and inflation rise again.

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What to Do?

As with all financial quandaries, there is no magic bullet solution for this dilemma. Some advisors are turning to alternative investments for higher yields. Jack Hillis, president of Hillis Financial Services in San Jose, Calif., is looking at high-yield bonds, REITs, and bank loan funds. Though the higher up you go on the potential bond yield scale, the greater the risk to your assets.

Indeed, Lex Zaharoff, head of the Investment Lab at Citi Private Bank, recommends not simply going for longer bond maturities or lower credit quality. He recommends also looking at master limited partnerships and thinking about asset allocation over all classes, including emerging market debt.

Porcelli advocates taking a highly flexible investment approach. "Look for investments in places you've never looked before," he said, including stocks and bonds around the globe. A long-term investment outlook is key.

Yet for those nearing retirement, the long-term outlook is no longer an investment option. Zaharoff said people often think in black and white terms when making investment decisions, but dramatic changes to a portfolio should not be made near retirement. "Don't sell all your equities at once," Zaharoff said. Instead, pare back stocks a few percentage points each year. "What's important is balance and making gradual changes," he added.

(Read More: When It's Time to Hand the Checkbook to the Kids)

How Much Will You Need?

Navigating an atypical investment landscape isn't the only retirement challenge. The flip side of that equation is under-estimating how much money you'll need during retirement. That can be a big mistake.

Since you're no longer accumulating assets, you need to think of retirement as being "costly." You'll need 80 percent of your preretirement income during retirement, said Ann Hughes, vice president at Iowa-based Sammons Retirement Solutions. "If there isn't enough money," she said, "you'll have to downsize or keep working."

The antidote is having a well-thought financial plan that can ride out good and bad times, but the truth is that many people don't have realistic plans, said Steve Vernon, author of Money for Life. "They don't have a systematic way to draw off income," he said.

Vernon advocates using guaranteed income streams such as pensions or Social Security to cover basic living expenses. Fixed dollar amount annuities are also helpful, which promise to pay a fixed amount over the duration of a life. The contract should also have an inflation rider that increases 2 percent to 3 percent each year, he said.

"Annuities are like do-it-yourself pensions," Vernon said, "so you don't outlive your assets."

Finally, as one thinks about an effective preretirement portfolio approach, health care costs must be factored into the equation. Four in six individuals will underestimate how long they will live, said Katherine Roy, chief retirement strategist at J.P. Morgan Asset Management. "It's a problem," she said, especially as the longevity curve lengthens and that demographic shift leads people to underestimate health care costs.

Roy recommends adding 5.8 percent to annual living expenses just to keep pace with rising health care costs. One in two people will probably need long-term care, she said. "People fear running out of money," Roy said.

Indeed, experiencing a twinge of preretirement panic is normal these days, after the shock of the financial crash and the decline in home values, which for many older Americans, was their largest nest egg. In the end, though, planning smartly is more effective than trading in anxiety.

_ By Constance Gustke, Special to CNBC.com

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