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THE WRONG NUMBER | |
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Investor's Insight - Wednesday, April 5, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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FINANCIAL PLANNING 2.0, PART 2:
THE WRONG NUMBER
by Scott Burns
Financial Planning 1.0 -- what most of us encounter through
advisers or on the Internet -- meet Financial Planning 2.0.
This eight-part series of columns, written by Laurence J.
Kotlikoff and me, explores the consumption smoothing app-
roach to lifetime personal finance. While the idea has been
developing for nearly a century, it has taken the power of
today's personal computers to build the necessary tools.
When we use these tools, we find that conventional planning
is more likely to lead us astray than take us to financial
security.
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 in-
volving 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 re-
tirement, 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.
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But this didn't work either. Larry's current spending
was far too high to maintain, and Scott's was ridicul-
ously 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 in-
credibly 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 expendi-
tures.
What to do? Well, Larry pulled out ESPlanner, the soft-
ware 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 ex-
penses. 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 main-
tains 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 set their number just 10 percent too
low, they will be told to save nothing at all. Clearly,
saving recommendations are highly sensitive to the number.
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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 they set 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 Web sites,
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 like-
ly to be dangerously wrong.
ON THE WEB
Laurence J. Kotlikoff's Web page:
http://people.bu.edu/kotlikoff
ESPlanner software Web page:
www.esplanner.com
"The Coming Generational Storm" (at MIT Press):
http://mitpress.mit.edu/catalog/item/default.asp
"The Coming Generational Storm" (at Amazon.com):
www.amazon.com/gp/product/0262112868/002-5379885-1560022
(Questions about personal finance and investments may be
sent to Scott Burns, The Dallas Morning News, P.O. Box
655237, Dallas, TX 75265; or by fax: (214) 977-8776; or
by e-mail: scott@scottburns.com.
Check the Web site: www.scottburns.com.
Questions of general interest will be answered in future
columns.)
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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