Q. Most questions in your column relate to people who have an investment portfolio for retirement income. When it comes to long range planning you suggest a percentage of the portfolio that can be withdrawn each year.

My situation is different. As a county employee my retirement contributions along with the county's share went into a state run retirement program. I recently retired after 30 years in the program. My retirement is a fixed amount with no provisions for a rise in the cost of living. My retirement income is greater than my paycheck before retirement. With the additional Social Security income and lower deductions from the retirement payment than from the paycheck, I am living comfortably for the time being.

I plan to invest some of the excess income in order to provide extra income in the future when increases in the cost of living will diminish the purchasing power of my fixed income. Can you suggest a formula or plan for the percent of my current income that I should set aside and the type of investment for this purpose?

---E.F., Dallas, TX


A. You're not alone. Many people face this situation in a more subtle form--- they retire with Social Security, a defined benefit pension, and some investment income. If they draw heavily on their investment income they won't be able to keep up with inflation in later years because a spending gap grows very rapidly.

The only way to compensate is to save in the early years of retirement.

Suppose, for example, you retired with $18,000 in pension income and $18,000 in Social Security benefits and spent $36,000 in the first year. If your Social Security benefits rose at 2 percent a year while inflation rose at 3 percent a year, the shortfall between your income and spending would be $3,035 in the 5th year, $7,460 in the 10th year, and would rise to $26,229 by the 25th year--- the combined life expectancy for a typical couple. It would take over $100,000 in savings (at retirement) to cover the cumulative shortfall.

The exact size of the shortfall will depend on how much your Social Security income rises, whether your spending continues to keep pace with inflation (many people start to spend less after age 75), etc.--- so there is no handy rule of thumb.

Testing a rough computer model I found that your savings needed to be around 15 percent of income---or more--- to build enough savings to compensate for inflation, assuming your savings earned around 9 percent in a balanced fund.


Q. Should I completely pay off my $400,000 mortgage at 7.75 percent, taken out in 1994, or should I continue to use it for interest deductions and reinvest my money? If so, what are your realistic expectations for annual returns and any recommendations? I would still have $50,000 in the bank, excluding 401(k)'s, for immediate cash needs.

---D.B., Dallas


A.   Since your mortgage dates to 1994 I'll assume your house is worth about $600,000 and has an annual real estate tax bill around $12,000. That is well over the standard deduction amount. This means every dime of mortgage interest is tax deductible. So your after-tax interest cost is 5.04 percent, assuming a 35 percent marginal tax rate.

You might also refinance the mortgage to a lower rate. Recent rates on 30-year jumbo mortgages in the Dallas area, quoted on www.bankrate.com, were as low as 6.5 percent. Switch to a variable rate, such as a 5/1 ARM, and the rate could go as low as 5.5 percent. This would give you an after-tax cost of 3.58 percent.

Now lets compare those net costs to expected stock returns. A number of academic studies have recently projected future equity returns at 6 to 7 percent a year. This is lower than the long-term average of 11 percent for two major reasons: dividend yields are low relative to historical norms and price to earnings ratios are relatively high.

Even with such dour expectations, remaining invested is likely to provide a higher return.

The people who should be thinking about paying off their mortgages are retirees in the reverse situation. They're paying 7 percent on an old mortgage with payments that are an even higher percentage of the loan balance (because of principal payments), their interest payments aren't deductible because the loan is relatively small, and their CDs or other fixed income investments are returning less than 4 percent.