Today's hottest personal finance book is Lee Eisenberg's "The Number." It's about the amount of money you need to retire. It's also, we're told, the path to self-knowledge, enlightenment, and inner peace. Because once you know your needs, you can actualize them.
After contemplating our needs, we figured out our numbers. They're kind of big. We're talking roughly $200 million for Larry and $10 million for Scott. Why the difference? Well, Larry is rather needy. He needs the Lear jet, the big yacht, a private island in the Caribbean, lots of attendants, etc. Scott has more modest needs, mostly involving a vintage trailer collection.
One catch. Neither of us can save anywhere near enough money to hit our numbers. Our needs, we realized, must fit within our budgets. Worse, the needier we are in retirement, the less needy we can be before retirement.
After lots of fussing about forgoing the jet and the trailers, we decided to set our retirement needs based on our current spending. This is what financial planners generally advise you to do — set your retirement-spending target based on your current spending.
But this didn't work either. Larry's current spending was far too high to maintain, and Scott's was ridiculously low. What we really needed to figure out was the most we could safely spend on an ongoing basis. This consumption smoothing would balance our pre- and post-retirement needs the way economics recommends.
Our "Eureka!" moment didn't last long. We next realized that determining our sustainable living standard is incredibly complicated, given all the interrelated factors, including future earnings, regular assets, retirement accounts, Social Security benefits, federal and state taxes, housing plans, estate plans, and special expenditures.
What to do? Well, Larry pulled out ESPlanner, the software program he developed that figures out one's highest sustainable living standard in 10 seconds. It told him to start living within his means. It told Scott to start living it up. It also got us thinking about the wrong number — about what happens when people set the wrong spending target for retirement as well as for survivors.
Retirement and widowhood can last a long time. So small targeting mistakes, since they're being made for so many years, can really screw up a financial plan. You could save far too much--- or far too little. You could buy silly amounts of life insurance.
We checked this out using ESPlanner for a hypothetical 40 year-old California couple, with two kids, a modest home, $125,000 in annual labor earnings, $75,000 in savings, a big mortgage, and lots of future college expenses. With the extra mouths to feed and the mortgage payments, the couple should save modestly — only $1,440 this year — and do a ton of retirement saving as soon as they've got the kids through college. This plan maintains the couple's living standard through time. It's based on the right number.
But what if the couple set their number just 10 percent too high? In this case, they will be told by conventional financial software (which makes you set your own target, rather than finding it for you) to save $11,955 a year. And if the couple sets its number just 10 percent too low, they will be told to save nothing at all. Clearly, saving recommendations are highly sensitive to the number.
What about life insurance recommendations? The couple need to hold $600,000. But if they set their target just 10 percent too high, they'll be told to hold $1,275,000. And if the couple sets their target just 10 percent too low, they'll be told to hold only $100,000!
Small mistakes in your number also mean large disruptions in your living standard at retirement, or if your spouse or partner dies. For our illustrative couple, targeting mistakes of 10 percent led to roughly 30 percent changes in living standard for retirees and survivors. This is consumption disruption, not consumption smoothing.
The really scary part is that a 10 percent targeting error is minor for conventional financial planning. For example, we consulted two of the best investment company websites, Fidelity and TIAA-CREF. Fidelity Investment's Retirement Quick Check calculator recommends a retirement spending target equal to 60 percent of annual earnings. For our stylized couple, this target is 36 percent too high. TIAA-CREF's Retirement Goal Evaluator recommends a retirement spending target equal to 80 percent of annual earnings. For our stylized couple, this target is 78 percent too high.
We think life's too short for target practice or wishful guessing. So read The Number, think about the number, but be advised that any number chosen by you or by financial planners using horse-and-buggy tools is likely to be dangerously wrong.
Sunday, Part 3
On the web:
Professor Laurence J. Kotlikoff's webpage
ESPlanner software webpage
The Coming Generational Storm (at MIT Press)
The Coming Generational Storm (at Amazon.com)
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