AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

Dear Scott,

Thank you for your work with Larry Kotlikoff--I always enjoy your articles and responses to threads.  I am really enjoying ESPlannerPlus and can't wait for your new book "Spend 'til the End" comes out.

I was reading some of Larry's working papers on his website and had two questions about information that seemed to conflict with what you and he wrote in The Coming Generational Storm:

1) In The Coming Generational Storm, you and Larry advise on pages 218-220 to "pay taxes today" wherever possible--Roth IRAs and taxable accounts--because of likely higher tax rates in the future as well as the tax trap of traditional tax-deferred accounts.  However, in Larry's working paper To Roth or Not?--That is the Question (http://people.bu.edu/kotlikof/New%20Kotlikoff%20Web%20Page/NBER%20WP%2013763%20To%20Roth%20or%20Not.pdf), the conclusion states "contributing to a regular 401(k) generates larger lifetime tax breaks for a majority of stylized working households than does contributing to a Roth 401(k)."  In the charts at the end of this paper, this preference for the traditional, deductible 401(k) appears to be the case for almost all people across income levels and even, to a certain extent, if there is a tax hike in the future.  What am I missing?

2) On page 215 in your book, the section heading reads "Save 'til it Hurts," and on page 217, you and Larry recommend that saving 20% of one's income would not be excessive to prepare for the future--one that seems fairly bleak according to the book's thesis.  My wife and I are saving close to this amount, but most of what I have read in Larry's consumption smoothing papers, several of your articles, as well as the results I get from ESPlannerPlus are (happily) telling us to ease up on the saving in favor of more consumption.  What am I missing?

Thank you for your and Larry's trail-blazing work--it is fascinating and quite a change from the traditional advice.

Bradley

Dallas, TX

Bradley,

 I think you'll like the book a lot. Although the book is entirely grounded in well accepted economic theory (life cycle finance and consumption smoothing) we wrote it to deliver the ideas through anecdotes and examples. The result is a pretty fast read.

We take a close look at the questions you ask in chapter 15 "Does It Pay to Play?" (pages 141-155) in Spend 'til the End. The general finding is that absent any future changes in tax rates, the choice between traditional and Roth saving will be a very close call. For many people it will be a matter of indifference--- not enough to get their attention.

More important, the difference is generally overwhelmed by another consideration.

For most people, contributing to a 401k plan will mean they can't achieve a level living standard throughout live.

They will have to reduce their living standard in their earning years (until sometime in their 50s) in exchange for a higher standard of living in later years. This, of course, is against the general idea of consumption smoothing which is to maintain a steady standard of living throughout life.

You don't get to see this using conventional financial planning software. It's a reality that only emerges when you have the power of dynamic programming in ESPlanner and can actually calculate a lifetime consumption standard net of all future taxes, etc. (For case studies, click on this link:

http://www.esplanner.com/illustrations.php )

If you assume an increase in future tax rates, however, the balance shifts in favor of the Roth over traditional.

How much you should save depends very much on what you assume about future tax rates. If you make the incredibly benign assumption that our government will deliver all that it has promised, most households (virtually all those with incomes below the SS wage base maximum, $102,000 this year) would have minimal need for saving provided they (1) eliminated debt prior to retirement and (2) had raised children. They would have a minimal need for saving because their SS replacement rate would meet their lifetime adult consumption standard.

For me (and I think I can speak for Larry here) it doesn't make sense to make such benign assumptions. ESPlanner also shows that saving, under most circumstances, will produce a net present value increase in lifetime consumption.

So you'll either have (1) a higher lifetime standard of living or (2) have a hedge against government failure to deliver promised benefits.

Scott 

Dear Scott,

Thank you for this reply--this is making more sense to me.  So, it is a balance between living well in the present and being prepared for a future with quite a few challenges--inflation, weaker dollar, higher taxes, lower investment returns, and reduced government benefits.  I was just feeling a bit of whiplash between the message to "batton down the hatches" in The Coming Generational Storm and the "live it up a little" message I am getting from E$Planner, your and Larry's consumption-smoothing articles, and now, the teriffically engaging Spend 'til the End.  Thank you for writing the book!

My wife and I (ages 31 and 32, respectively) are trying to find this balance--namely, we're trying to decide when to move "up" to a bigger house as we plan to try having 2 or 3 children in the near future.  Here are our details:

Combined Roth IRAs & Roth 403(b)s: $172,000

Combined 403(b)s & SEP-IRA: $143,000

Fidelity Variable annuity: $12,000

Taxable: $55,000

529 (originially opened for me; not used; saving to change beneficiary to future child): $9200

Cash reserve: $13,000--about 3 months of living expenses 

House: $200,000 w/ $135,000 4.625% 5/1 ARM (to reset 5/2009) & $12,500 15-yr. 6.99% fixed 2nd mort.

Annual income: around $200,000 (w/ excellent credit)

I'm the "oversaver," but my wife is conscientious as well.  We would like to be financially independent sooner rather than later (i.e., not dependent on an employer) and also able to help with the chunk of future college expenses that are not covered by scholarships and our children's required contributions.  Because of compounding, I have been happy to delay gratification to "front load" our investments.  We're trying to decide on how much we can pay for the next house--between the large range of $300,000 and $500,000.  I am fearful of saddling us with payments that are too large, but I also want to raise our living standard some in the present as a result of your book, E$Planner, etc.  Also, we tithe at least 10% of our income, so the mortgage interest deduction is good for us, especially for our age and proclivity for investing mostly in stocks.

Do you have any guidance about where in the housing price range we should be looking?  Also, how many years away is a likely "Financial Independence Day?"  Finally, given that our 2-3 children may all be geniuses and receive full scholarships OR may need a good chunk of help paying for college, how much & where should we save for them?  (All three of these questions have kept us in a "triple bind" of "if this, then that, but not that or that....")

Thank you for your help, Scott--we appreciate it.

Bradley

Bradley,

I think the cross-current you detect--- the differences between 'Storm and 'Spend--- is that 'Storm was sounding the alarm about the degree of "policy risk" we all face. The only way to compensate is to save more. How much more depends on assumptions. In other words, how much is a crystal ball reading exercise.

In 'Spend we took a different approach. We noted the policy risk but assumed a normative world in which the government fulfills its promises. Then we changed the other variables--- the decisions we can make as individuals that will effect our lifetime consumption. We were looking for things that were actionable rather than moves dependent on either government or markets. We did this because Larry and I share a strong belief in the power of individual adaptation.

Your question about the amount of house to buy is fascinating. Larry and I have been talking about exploring whether there was an optimal debt level figure and will be working on it this summer. So stay tuned--- it's likely to be a future column.

Scott

This is great, Scott.  Thank you for your comments, and I look forward to reading more from you and Larry--especially about optimal debt level figures across a lifetime--specifically finding this balance of using the "good debt" (i.e., mortgage) prudently in balancing current and future consumption.

Thanks as always for your trailblazing work and for putting our many choices into perspective.

Bradley

Dear Scott,

I know you have your head and hands full covering the current economic crisis.  I was wondering if you and Larry have done any more work on an article addressing an optimal debt load for different ages and/or wealth levels.  Given all of the forced deleveraging happening right now in corporations and homes, I am very interested in what you might have to say about this at this particular juncture.

Personally, my wife and I have moved ahead with our plans to build a new home here in Dallas, and completion is scheduled in three weeks.  Although we were not depending on it, we have just come to an agreement with a buyer for our current home, and we just locked the interest rate on our new home with Chase for 5.125% 30-year fixed.  All in all, we are extremely grateful.  To the point, though, while many are deleveraging, we have been (thankfully!) in a position to increase our leverage through a 95% mortgage via our top-notch credit, no debt other than an $8400 5.5% student loan and our mortgage, and about 1.5 years of our income saved in stock mutual funds across retirement and taxable accounts.  We are 33 and 31 years of age.

 While we are likely not typical, I would be very interested in your thoughts on optimal debt load throughout a life cycle...whenever you get the chance!

Thank you, Scott, for your always valuable insights!

Bradley

Bradley,

In answer to question 2, the need to save more comes from assuming higher inflation rates for future Medicare premiums, higher taxes on income (including Social Security benefits, and possible higher inflation. If you assume that everything will just go along as it is now, ESPlanner will frequently show people that they are oversaving and can reduce the amount they are putting away.

"Spend 'til the End" was published in June by Simon & Schuster so you can now get it on Amazon or your local bookstore. Answering the question--- to Roth or not--- turns out not to be one that you can say "this is the way to go" because there are so many variables.

What IS certain is that participating in a plan of either kind will reduce your standard of living in all years before age 51 and increase it in all years after that. We found, surprisingly, that there was a small advantage to a conventional IRA over a Roth, regardless of your starting age is you made the benign assumption that future tax rates will be the same. This is laid out in Chapter 15 of the book, "Does it pay to play?"--- the chapter devoted to the question of relative benefits of the two kinds of plans.

Scott

Dear Scott,

I believe you just replied to a post I made back on May 31.  My most recent post (12/19/08) was regarding optimal debt levels for various people at various ages.

 Thank you, Scott, and Merry Christmas to you and your wife!

Bradley

Dallas, TX

Bradley,

You've asked a fascinating question, one that ESPlanner doesn't deal with directly. It can, however, give you the answers if you play "what-if" with the variable of how long you intend to work.

Let me phrase the question so we're on the same page. Those with high incomes, such as $200,000, have a choice of front-loading their savings with the goal of shortening their working careers or of increasing their spending to fulfull a conventional work life with retirement around age 65. Just as most people can work their way out of inadequate savings by retiring later, those with generous incomes who don't feel a need to spend to capacity can decide to shorten their work lives and lengthen their retirement years.

Just as a few years of additonal work improves retirement income materially, a few less years of additional work has a fairly hefty impact on your retirement income. In spite of your young age, however, I share your concern about getting into a mortgage that commits a significant part of your income. I might feel differently if you lived in a lower real estate tax state but Texas real estate taxes are one of the reasons homes in Texas as so reasonably priced. When you sign on for that big mortgage, you also sign on for a real estate tax bill that will go on long after the mortgage has been paid off.

In the current economy, we should all err on the side of under-buying our houses. I would not be at all surprised if many of the "McMansions" that have been built all over America start to look like the large "white elephant" houses of the 20s.

I've never favored special programs for college savings because the benefits have never, in my view, been greater than the restrictions--- even in 529 plans. You have the means to save and invest. If you suffer a loss you can use it to offset gains. And when it comes time to pay the tuition bills you can gift shares to the kids and they can realize the gains at very low cost. That's flexibility and low tax costs, particularly if you invest in equities. You retain control of the money and if your kids decide they'd rather, say, own a franchise business than go to college, well, you'll have the money and the choice rather than a college-dedicated program and its restrictions.

Scott

Dear Scott,

Thank you so much for these thoughts--very helpful.  Out of curiosity, what would you define as a McMansion?  Our home will be 3000 sqare feet, 4 bedroom, 2.5 bath with an unfinished space (280 sq. ft.) we could finish out later to add another bed and bath as our family grows, if we wanted more space, etc.  The home is in the L-streets area of Lake Highlands area of Dallas where new construction (i.e., tear downs of small rental houses and rebuilds) are starting to happen.  Our "finish out" will be very nice with granite, marble, travertine, very nice crown moulding, etc.

I work in Highland Park, so I certainly see many houses I would call McMansions (and quite a few Mansions!).  I'm just curious as to what might define "over-the-top" and hence, possibly less desirable in the future.

Thank you for your thoughts, Scott.  I appreciate your help.  Merry Christmas!

Bradley

Bradley,

At your age mortgage debt is likely to work as hard for you, as it works against older people.

We may be worrying about deflation today, but inflation is more likely part of our long term future. That argues for young people taking on debt. It does not, however, argue for listening to the lenders who might allow you to have debt that was 3x or 4x income.

People regularly forget that the lenders don't care about your quality of life, they only care about whether you can make payments on the loan. Worse, they haven't been shy about pushing the limits. Your income indicates you'll still be conservatively financed.

Another factor argues against a major home commitment.

Because Texas relies so heavily on the real estate tax and has no income tax, the shelter decision is particularly difficult. Owning a house in Texas means you are committing to an annual tax burden equal to about 2 percent of the value of the house, a value that can be adjusted upward virtually at will by the taxing authorities. So if you buy a house that is 3x your income, you're volunteering for a lifetime tax of 6 percent. The tax rate will be even higher when you retire and your income declines.

Worse, the tax burden tends to shift toward homeowners in tough times. In the broad recession of the late 80s, for instance, the percentage of Dallas taxes paid by homeowners increased while the percentage paid by commercial properties decreased. So homeownership in Texas is a lifetime commitment to a major tax liability. I believe that is one of the reasons that home prices in Texas are so reasonable relative to the coasts.

With 3,000 square feet, my guess is that you're near the optimal limit on how much house you should own. Remember, one rule of thumb says that a 3,500 square foot house is the limit for what you can handle without help. It's also a generous amount of space and, ironically, you'd find that many of the Highland Park "mansions" from 20s had 3,000 to 4,000 square feet of space. When they were built they were about 4 times larger than the average house. You can do an great deal with that much space. It's only the new lot-ploppers that have added more space.

"Over the top," in my view, would be any house that is much over 4,000 square feet with extra tall ceilings, lots of special two-story spaces, and sited with absolutely no regard for thermal load. These houses could easily become a major operating cost burden in the future as the cost of energy continues to rise. Sadly, while much of the older housing stock in Dallas was built with great attention to heat gain, avoided major southern heat exposure, etc. Dallas developers in the last 20 years appear to be totally clueless about siting and routinely build houses with two story high glass exposures.

The bottom line here is not a number. It's a personal choice. If your home is important to you, you make the commitment with the foreknowledge that it will limit some other choices. If early retirement is your most important goal, you'll limit the size of your house or be prepared to sell it when the last kid has entered college.

Scott

This is VERY helpful as always, Scott.  I really appreciate you and your expertise.  Thank you!

Bradley