Laurence Kotlikoff, Contributor
May 22, 2023
This is an extremely tough question to answer on your own. The number of major, interconnected factors includes your retirement age, the return you can safely earn on savings, the inflation rate, your retirement accounts, your regular assets, your mortgages, student loans, and other debts, your earnings, your federal FICA and income taxes, your state taxes, your future Social Security benefits, your Medicare Part B premiums, your housing costs and plans, your marital status, the ages and presence of children, your spouse’s earnings and assets, and ...
Economics alone can’t tell you what to do. But economics does provide a general guide to answering this question. It’s called consumption smoothing — the goal of maintaining your spending (your living standard) as you age. This, in turn, means spending this year only what is consistent with spending the same amount (measured in today’s dollars) in each future year.
Once you’ve figured out your sustainable spending, just subtract it from this year’s income and, voila! , you have this year ’ s required saving. This is very different from what conventional planning, aka Wall Street, advises.
Wall Street’s general advice is to keep saving whatever it is you’re saving, set a high post-retirement spending target based on the 85 percent replacement rate rule of thumb — target to spend annually in retirement 85 percent of your pre-retirement spending — and invest as aggressively as needed to meet “your” target. Aggressive investing raises the probability of “success” — spending throughout retirement at the targeted level without going broke. But it also raises the probability of your going flat broke at an earlier age, such as 65 rather than 85.
If economics teaches us anything, it’s that there is no free lunch. You can’t take on more investment risk without incurring more spending risk. It’s that simple. Economics also teaches us that no one rational person of even limited means would adopt a plan with any probability of ending up eating Friskies or being unable to buy medications or being forced to live on the street.
Checking Your Financial Acumen
I’m now going to play a game with you. I’m going to give you the case of a single person, named Frank, and let you tell me how much he can spend, such that he can keep on spending the same real amount through age 100 — his maximum age of life. I’ll also ask you to tell me what Frank should save this year. Once you’ve made your guess, look at the end of this column for the answers. They were computed in a half second each using software I’ve developed.
You will surely fail this quiz, just like I failed it even though I developed the software. No human can think 30 moves ahead in chess. And that’s a good analogue to the complexity of personal financial decisions.
But if you can’t figure out what Frank should do, you surely can’t figure out what you should do. Of course, you may be engaging a financial planner. But can your financial planner answer this quiz? Check. Send them the quiz, but not the answers. If they also fail, you need to face the obvious. Your planner is likely giving you the wrong spending and saving advice and, potentially, endangering your retirement.
As for those of you who don’t use financial planners, they are, it appears, assuming that the combination of Social Security and their employer’s saving plan will keep them solvent even if they make it into their nineties. But when we come up short, Uncle Sam and our employers will hold hands and recite:
Not my problem. We tried to help, but you needed to figure out what more to save on your own, not just rely on us.
The Six Part Quiz — How Much Does Economics Say to Spend and Save?
CASE A: Frank is an age 50 New Mexican making $130K annually. Frank’s earnings will keep even with inflation until age 62 when he’ll retire and immediately take Social Security. Frank started working at 25 in 1998 earning $50K. He nominal earnings grew each year by 3 percent. (This is important for you to figure out in your brain Frank’s future Social Security benefits.) Frank has $250K in savings on which he earns 4 percent. Inflation is running at 2.5 percent. Finally, Frank has a $1 million house with a 20-year $700K mortgage on which he’s paying $4K per month plus $10 annually in other expenses. Frank’s maximum age of life is 100 and he has no plans to sell his house.
How much can Frank spend, in today’s dollars, for the rest of his potential 50 years and still cover his housing costs, taxes, and Medicare Part B premiums? Also write down what Frank needs to save this year as part of his plan to preserve his living standard.
CASE B: Frank decides to change one thing — take Social Security at 70.
CASE C: Same as Case B, but Frank works till 67.
CASE D: Same as Case C, but Frank moves to Texas at 70.
CASE E: Same as Case D, but Frank downsizes his housing in half as part of moving to Texas.
CASE F: Same as Case E, but Frank plans on lowering his spending by 0.5 percent annually after age 75.
To keep you from peeking, I’m going to make some general points about the answers. First, Case B entails higher sustainable spending and requires less saving than Case A because Frank’s lifetime Social Security benefits are far higher — 76 percent per year adjusted for inflation — if he waits to collect. Case C features even an higher permanent living standard and even less current saving. As with Case B, having more resources, in this case, more future earnings, means there is more ability to spend in the present as well as in the future, but also less need to save. Moving to Texas goes the other way. On the one hand Frank doesn’t need to pay state income taxes after age 70. But moving comes with a 6 percent transactions fee for selling Frank’s house. Downsizing the house as part of the move and playing to spend less after age 75 —- both of these moves let Frank spend more now and later with less need to save.
These answers show that sweating your plan’s details matters. Between Case A and Case F, Frank’s required saving this year drops by three quarters! The answers also show that, when it comes to deciding how much to save, Social Security optimization is hugely important, that working longer can make a massive difference to one’s current and future living standard, that selling your home entails substantial costs, that sitting in a larger than required house can be extremely costly, and that intentionally planned cut backs in spending in old age, in order to be able to spend more early on in life and not need to save as much, can matter, but less than one might think.
The biggest takeaway is that the saving, above and beyond what we are doing within Social Security or through our employers, that is required to guarantee a stable future living standard is potentially enormous. Frank, like so many middle age households, has saved far too little. Hence, he needs to save a massive amount — almost half of his disposable income (income less taxes less housing costs) — in Case A. Yes, as the answers show, there are ways to reduce this requisite saving dramatically. But failing to take those steps, let alone save adequately given whatever moves Frank decides to make, will lead to a potentially huge decline in Frank’s living standard in retirement.
To summarize, as the saying goes, old age ain’t for sissies. It ain’t for physical sissies and it ain’t for financial sissies. We all need to be planning for what’s coming and not guessing or hoping our way into destitution and disgrace.
Case A: Frank’s sustainable discretionary spending is $42,912. His required saving is $41,108.
Case B: Frank’s sustainable discretionary spending is $51,631. His required saving is $32,389.
Case C: Frank’s sustainable discretionary spending is $59,632. His required saving is $24,388.
Case D: Frank’s sustainable discretionary spending is $58,305. His required saving is $35,715.
Case E: Frank’s sustainable discretionary spending is $71,204. His required saving is $12,816.
Case F: Frank’s sustainable discretionary spending is $73,289. His required saving is $10,732.
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