The Number: Retirement Planning Gone Wrong
The Number: Retirement Planning Gone Wrong
Laurence J. Kotlikoff, 01.22.10, 12:50 PM ET
"What's your number?" This is the standard question posed by conventional financial planning which asks, in essence, "How much money do you need to retire?"
But it makes no sense to me or other economists I know. When asked this question, my immediate response is "$1 trillion." I figure that will get me by. But then I realize that hitting that target would be rather tough--actually, downright impossible.
On the other hand, if push came to shove, I could live on the street and panhandle, so maybe $0 is all I really need in retirement assets. But that's not right either. I don't want to splurge now and starve later. Nor do I want to starve now and splurge tomorrow. What I really want is a smooth living standard over time. That's what we economists call consumption smoothing.
Consumption smoothing is not up for debate as a theory of typical behavior. The evidence hits you over the head. If people didn't want to smooth their living standards, they'd spend every penny they earned the minute they earned it and go hungry between paychecks. They'd also show up in retirement with absolutely no savings whatsoever.
Yes, there are plenty of poor people who save very little, but most are staking their retirements on Social Security, Medicare and Medicaid, which may provide, on an after-tax basis, a higher cash income (plus in-kind benefits) than they earned when they were young. There are also plenty of middle-class and rich people who save too little and others who save too much, but virtually all would say they'd like a stable living standard through time. The difference between what they say they want to have and how well they achieve that end may reflect a lack of self-control, over-anxiety about needing money in the future, bad or good luck or simply the fact that finding one's N(umber)-spot is damned tough.
OK so finding my N-spot connects to stabilizing my living standard. So to find it, maybe I should simply add up all the money I now spend on everything--my silk pajamas, my personal trainer, my BMW 7 series, my club dues, the shopping sprees to Paris, quarterly rest stops in St. Barts, maintaining the Lear jet and my $150 cigars--to figure out what number (that is, the amount of retirement assets) I must have to maintain my current life style.
But, darn it, that can't be the right path to my number. What if, heaven forbid, I'm spending too much? If so, I'll end up with a super high wealth target, have to save a ton to meet it, and be told to live like a pauper until 65--the point at which I can party again. Ugh! That means starving now to splurge tomorrow.
So maybe I should add up my cousin's spending? He makes the same as I do, has the same assets, family structure, etc. But he sleeps in the nude, shops at Costco, makes his own lunch, goes camping, exercises without help, drives an old clunker and lives in a shack. But if I add up my cousin's spending, my target will be bubkes, and I'll be told to splurge now and starve tomorrow.
Man, finding my N-spot is tough. And if I am--by sheer, crazy accident--spending and therefore saving just the right amount now--then why do I need a target at all? I already have the answer for how much to save: the amount I'm now saving!
OK, enough guesswork. Let's let economics cut to the chase. The N-spot we really seek is the precise amount of assets needed at retirement to provide the same living standard after retirement as that we enjoy before retirement (or as close a match as possible without going into debt). Finding your number is, in fact, a highly complex mathematical problem that needs to be solved using a technique called dynamic programming. (We economists teach all our Ph.D. students dynamic programming in their first year in grad school.)
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But the financial industry isn't into finding the right number. It's into making sure the number is big, because the bigger "your" number, the more assets you'll give them to manage and--drumroll--the more asset management fees they can charge.
Take, for example, Fidelity's My Plan, which says you need to spend 85% of your pre-retirement income in retirement. This target is miles too high for most households and produces a number that's likewise miles too high.
Fortunately, ESPlannerBASIC lets you do the proper dynamic programming in two seconds for free. (Full disclosure: My company created ESPlanner and sells advanced versions of this tool. But we sell no financial products.)
Take Fidelity's My Plan default case of a household, headed by a 45-year-old with $75,000 in income and $80,000 in assets. According to ESPlannerBASIC, such a household, if it invests safely, earns only 2% after inflation (roughly the amount long-term Treasury Inflation Protected Securities are now paying), and lives, let's assume, in Maryland, should target to spend 41%, not 85%, of its pre-retirement earnings now and after retirement.
To see precisely how nuts 85% is as a target (unless you're into gambling), run ESPlannerBASIC in conventional rather than economics-planning mode (choose this option under "Assumptions"). Set the post-retirement spending target at Fidelity's value--$63,750, which is more than twice the $30,620 ESPlannerBASIC says can be spent (above and beyond taxes and future Medicare premiums) each year from age 45 to 100.
The results will show huge negative values of spending prior to age 65. You can't spend negative amounts, so this is ESPlannerBASIC's way of throwing up. It's saying, "Spending $63,750 each year from age 65 through age 100 is not remotely feasible. Even if you save and invest every single penny you earn after taxes between now and age 65, you can't accumulate the $1.75 million Fidelity says you need at age 65 (let alone the $1.6 million ESPlannerBASIC says is needed for that living standard).
To be fair, Fidelity also lets you know that investing safely won't let you hit "your" N-spot. But Fidelity then invites you to use My Plan's investment sliders and shows that if you invest aggressively and earn average returns, you can get much closer to "your" target.
This may sound like reasonable advice, but it's actually a bait-and-switch strategy and hardly unique to Fidelity. The financial industry sets targets that are far too high and then induces us to buy riskier investments with higher fees to supposedly reach these targets. It can also cost us our retirements. Fidelity's "market performs poorly" results aren't the real downside; the real downside of investing in highly risky securities is losing everything.
The financial industry, as we've been reminded of late, is not the average person's friend. The industry's financial "advice" is one area that the Consumer Financial Protection Agency, if it's ever established, should examine very closely.
Laurence J. Kotlikoff is a professor of economics at Boston University, president of Economic Security Planning, author of Jimmy Stewart Is Dead--Ending the World's Ongoing Financial Plague With Limited Purpose Banking, and co-author, with Scott Burns, of Spend 'Til the End.