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