Too Much of a Good Thing?
An Economist Explains How to Save What You Need for Retirement and Spend What You Need Now| From Perspectives | By Laurence Kotlikoff
Illustration by Harry Campbell
Your ten-year-old will get this right. Put him in front of twenty cupcakes and invite him to eat as many as he wants. He'll inhale the first, gobble down the second, and take his time with the third. Suggesting he go for a fourth will elicit the following response: "Let's save some for tomorrow." In squirreling away cupcakes, your ten-year-old is engaging in consumption smoothing: trying to maintain his living standard not just over time (today and tomorrow), but also across times—good ones (sweet-tooth dad did the shopping) and bad ones (sensible mom did the shopping).
That's a basic premise of the life-cycle model, an economics-based approach to personal financial planning developed over the last century. Leading economics journals are full of studies that use sophisticated mathematics and lots of computing power to solve ever-more-elaborate life-cycle, consumption-smoothing problems. These studies also show that household financial decisions deviate widely from what the models predict—and that households routinely make major financial mistakes.
This is not surprising. None of us has a Pentium IV chip implanted in his brain. In recent years, behavioral economists have been teaming up with psychologists and neurologists to understand more precisely how our neural circuitry affects our financial judgments. That's intellectually intriguing, but it's of little practical help to households in making complex consumption-smoothing decisions. What they need are the tools required to get these decisions right—the same tools that economists use.
Price your lifestyle decisions in terms of their living standard impacts. Whether it's buying a boat, sending your child to private school, having another baby, or retiring early, there's always a living standard price to pay.
The financial planning industry doesn't help. Conventional planning software makes you set your own future spending targets for retirement, something that's nearly impossible for most households to do. Think about all the interconnected factors—your age, your spouse's or partner's age, your children's ages, labor earnings, mortgage payments, regular assets, federal and state taxes, Social Security benefits, pensions, 401(k) accounts, college tuition, estate plans, housing plans, retirement dates, and Medicare premiums, to name several. Get any of these factors wrong, let alone their interplay, and you'll set the wrong spending target. Even small targeting mistakes, since they are being made for forty or so years of potential retirement, can lead to very bad saving and insurance decisions.
Confused? The financial industry is quick to the rescue. It has developed a rule of thumb for setting the "right" target: you should plan to spend each year in retirement about 80 percent of your preretirement earnings. Unfortunately, this advice is designed to sell mutual funds and insurance products. It's not designed to help us achieve a stable living standard.
For almost all households, following this rule will have you saving far too much and buying far too much life insurance. That may seem safe. In fact, it's risky. If you save too much when you're young, you run the risk of dying before you get around to enjoying your money. And if you buy too much life insurance, you run the risk of never collecting because you live to a ripe old age. Worse yet, you can easily be talked into investing in highly risky assets in order to raise the chances of meeting your target.
Economics is focused on living standard balance; it's focused on making you happy, not enriching your financial advisor, retirement-account provider, or insurance agent. So what do you really need to do to plan for retirement? My first piece of advice is to steer clear of rules of thumb and conventional financial advice. Do not go to your mutual fund's Web site and use its five-question calculator to figure out how much to save or how much life insurance to buy. These tools and the thousands like them elsewhere on the Web represent forms of financial malpractice. No physician would last long giving you a two-minute checkup and then selling you drugs. But this type of behavior goes on 24/7 in the financial services industry.
What consumers need are economics-based tools that use the life-cycle model to help you raise your standard of living. (Full disclosure: With the support of Boston University, the National Institute of Aging, and other economists, I developed a program called ESPlanner, Economic Security Planner. It's the first of what I hope will be many such tools to come.) These tools won't ask you what you'd like to spend in retirement. Instead, they will tell you what you can spend in retirement, and every year leading up to it, if you'd like to have a smooth ride—a stable living standard per household member. They find the right spending targets for you. Once you've set up a basic plan, you can determine in short order whether to contribute more to a retirement account, which retirement account to use, when to take Social Security, whether to repay your mortgage, whether to switch jobs, whether to move to New Hampshire, and so forth. In each case, the answer depends on whether making the particular decision will raise or lower your living standard.
My next proposal is to price your lifestyle decisions in terms of their living standard impacts. Whether it's buying a boat, sending your child to private school, having another baby, or retiring early, there's always a living standard price to pay. We can't make the right set of decisions in these spheres until we know what each decision costs. And with today's software, you can learn these prices almost instantly.
My final instruction is to protect your living standard. That means saving the right amount year in and year out. It also means holding the right amount of life and other forms of insurance. And it means investing in a way that limits your living standard risk. The new software can help you here as well. It shows you how different investment strategies affect the level, but also the spread, of your living standard through time.
After a century, economists are realizing that they have a responsibility not just to study financial pathology, but also to try to cure it. Their new medicines aren't panaceas, but they can go a very long way to helping you smooth, raise, price, and protect your living standard.
Laurence Kotlikoff is a professor of economics at the College of Arts and Sciences. His latest book is Spend 'Til the End: The Revolutionary Guide to Raising Your Living Standard—Today and When You Retire (Simon & Schuster), written with Scott Burns. For more information about ESPlanner (Economic Security Planner), visit www.esplanner.com.
You Asked, We Answered
Many readers took advantage of our invitation to ask Laurence Kotlikoff, professor of economics, about what they can do to build and protect their retirement savings. Here some of those questions, along with Kotlikoff's responses.
QI am retired. I am 84 and my wife is 76. My problem is that my financial advisor over the last two years put me in AIG, Fannie Mae, and Goldman Sachs bonds. What is the probability that AIG will default or go bust? Would your program help me in picking appropriate fixed-income bonds? — Joseph Mason (CLA '46)
AFire your financial advisor. AIG is now a government company. It won’t go bust. Your bonds sound safe from default, but not from inflation. I recommend inflation-indexed bonds sold by the Treasury. The ten-year Treasury Inflation-Protected Securities (TIPS) are yielding close to 3 percent after inflation.
QI am retired and my portfolio is mainly in index funds, which have low expense ratios. I have used Vanguard bond funds for the fixed-income portion of my portfolio and, because I aim for funds with the lowest expenses, I recently invested in bond index funds. I have been rewarded with income from the funds, but the share price is now down considerably. Since I thought the bonds held by these index funds would be high-quality investment grade bonds, I am surprised and disappointed with the loss. Should I be buying individual bonds instead of bond index funds?— Phyllis Cohen
AAgain, I recommend long-term TIPS. The return is great, all in all, and they’re as safe as it gets.
QI am already contributing more than the maximum amount to receive matching funds to my 403(b). I am not contributing the full maximum amount. I plan to retire in six years. Should I make additional payments to my 30-year fixed mortgage? My other investments are mostly in CDs, earning less than my 5.375 percent mortgage rate. Will it lower my ability to deduct mortgage interest payments on my taxes, if I pay off more on the principal?— Wendy Schwartz
ATough call. Tax-wise you do better putting the money into the 403(b). Also, the prices of stocks are now very low. But I like paying off the mortgage because it’s a safe return.
QI am a 25-year-old graduate student in SMG and I work full-time. My new company does not have a 401(k) plan for employees. I have approximately 17K in my previous 401(k) and I am unsure what to do with it. I have contemplated leaving it where it is and weathering the economic storm because obviously it is a long-term investment. Should I roll it over to either my Roth IRA, and take the hit in fees, or to a new standard IRA?— Lance Etzin
AI recommend that you invest it in a low-cost stock index fund either in the 401(k) or in an IRA.
QHow much life insurance do retirees need, assuming they have sufficient savings to fund a comfortable retirement?— Jeff Miller
ADepends on a number of factors. The answer may be none; www.esplanner.com (my company’s website) has a program that makes life insurance recommendations that I feel are appropriate.
QI am 52. After a few post-doctoral degrees, I have been employed teaching since 1991. I’m late to retirement saving due to my education, so I have been maxing out my retirement contributions to catch up. My employer puts 8 percent of my salary into retirement annually. I have seen an almost $60,000 drop in my retirement savings (currently in the neighborhood of $265,000) and figure some of my assets will stay in moderately aggressive stocks for a while. I figure I cannot afford to retire until age 67 at the earliest, perhaps even age 70. I have a moderate lifestyle and no children, and therefore no life insurance. I do not see my lifestyle changing after retirement. What is the current projection for “necessary” retirement assets as we go forward in today’s economic climate? How much is enough?— Deborah Barr (SAR '88)
ADeborah, I recommend riding this out and making sure your stocks are invested in an index fund. I wouldn’t try to pick individual stocks.