Resurrect Your Retirement
Resurrect Your Retirement
Laurence J. Kotlikoff, 04.07.09, 12:00 PM EDT
An economist offers five steps to get one couple's plan back on track.
If you're like me, you've watched your assets get massacred by the malfeasance system we call American capitalism. Insider rating, captured politicians, regulatory "restraint," director kickbacks, off-balance sheet accounting, non-disclosure, fraud, moral hazard, thieving CEOs, Ponzi schemes ... you name it, we've got it.
The natural reaction to seeing one's assets evaporate and reading about Wall Street bonuses is rage. But that's no answer. The best we can do is pull up our shirt sleeves and make the best of a very bad situation.
Yes--easy to for me to say, given that I'm an economics professor with tenure. But I know there are 12.5 million Americans out of work and tens of millions more frightened to death that they're next to lose their jobs. I also know that we economists bear our share of the blame for the financial debacle. The economy is our patient, and we missed plenty of early signs of its heart failure.
I'm also worried that the Summers-Geithner brain trust is violating the Hippocratic Oath--First, do no harm. The financial system is short of trust, not money, and using complex, leveraged schemes to transfer hundreds of billions from taxpayers to bank shareholders does nothing to restore trust.
My solution here is Limited Purpose Banking. It turns all banks and insurance companies into pass-through mutual funds and permanently shuts down their ability to gamble at the nation's expense. It restores trust in the only possible way--by guaranteeing what's happened can never happen again.
With this financial fix, America will slowly recover. But for those nearing retirement, assuming the market will rebound is too risky. Instead, I recommend building the highest safe floor under your retirement.
Let me illustrate the strategy by running Jack and Jill--an empty-nest, 50-year-old, hypothetical Wisconsin couple who've just lost a half million in the stock market--through ESPlanner, an economics-based, financial-planning program my company developed. The program calculates your sustainable living standard and shows you ways to safely raise it. Living standard means your discretionary spending--your spending after paying taxes, making contributions to retirement plans and paying for housing.
Jack and Jill's remaining assets consist of $250,000 in taxable accounts, $250,000 each in their 401(k)s, $150,000 each in traditional pre-tax individual retirement accounts, plus a house (they want to keep for their kids) with a $350,000, 25-year, 6.5% mortgage.
Jack and Jill's biggest asset is their blessedly secure jobs. They each make $125,000 a year and still plan to retire at 65. Both spouses are contributing 6% of their salaries to 401(k)s, and their employers are putting in 3% of their salaries as a match.
Jack and Jill's biggest liability is their maximum lifespan: 100. They can't count on dying before that and, therefore, need to develop a plan that will allow them to continue to spend to the end.
The haven't called it quits on the stock market, but they are investing now primarily in long-term Treasury inflation-protected securities and expect to earn just 3% after inflation on their money.
Avant le deluge, Jack and Jill were counting on the $500,000 they've lost and high stock market returns to see them through old age. That is, they were saving nothing other than their 401(k) contributions and paying off their mortgage. Staying this course going forward is a prescription for disaster--it will entail a 42% drop in their living standard when they retire.
To achieve a stable living standard, the couple needs to "smooth consumption." That means reducing their current living standard by 29% so that they can save enough to maintain the same standard in retirement. Since their annual discretionary spending is now $143,680 (measured in today's dollars), lowering it to the sustainable $101,916 per year would be a huge adjustment.
Fortunately, Jack and Jill can raise that baseline living standard with zero risk, primarily by taking Uncle Sam's best deal. Here are five steps they should take.
Contribute more--12% of salary each, rather than 6%--to their 401(k) plans. Doing this lowers the couple's lifetime taxes and lets them spend $105,253 on an ongoing basis. That's 3.3% better than the baseline living standard.
Wait until age 70 to collect Social Security.
This strategy raises their benefits by one-third when they start to collect. Now Jack and Jill can spend $110,934 each year. That's an 8.8% higher living standard over the baseline living standard.
Refinance their mortgage, paying points to get a very low--4.5% rate. This strategy moves their annual spending power to $111,575. Now we've raised their living standard by 9.5% above the baseline.
Convert their pre-tax IRAs to Roth IRAs in 2010 when the current restriction, which allows only those with modified adjusted gross income of $100,000 or less to convert, is scheduled to be lifted. This means much higher taxes next year, but much lower taxes later in life, permitting the couple to spend $113,758 each year. We are now 11.6% above our baseline case. The reason is that future Roth IRA withdrawals won't be counted as part of AGI, which is used to determine how much taxes the couple pay on their Social Security benefits. Converting to a Roth to save taxes on Social Security benefits? Weird, but true.
Use half of their 401(k) assets to purchase inflation-indexed annuities. This sounds like disinheriting their kids. But it's really the opposite. The annuities purchase, by giving the couple a greater ability to spend--$119,133 annually, a 16.89% increase over the baseline case--means the children don't have to worry about shelling out for dad and mom's expenses if they live to 100.
The bottom line? With the right financial moves, Jack and Jill can spend 16.9% more each year for the next 50 years at no extra risk if, and this is huge if, there are no changes in their projected earnings, tax hikes, Social Security benefit cuts, unexpected health costs or problems with the insurance company selling them their annuities.
Life's neither sure nor fair, but economics can help us move ahead through our terrible financial storm.
Laurence J. Kotlikoff is a professor of economics at Boston University , president of Economic Security Planning and co-author, with Scott Burns, of Spend 'Til the End.