Every week, one financial services firm or another releases findings of its
latest retirement study: Americans aren’t saving enough. The savings rate is
abysmal. Americans keep up with the Joneses at the expense of their golden
years. They borrow against their homes to pay for luxuries and so forth. But is
the situation as dire as most people think? A New York Times story on
Jan. 27 cited a handful of academics who think Americans are saving plenty—too
much, in many cases.
Who is right?
There is no definitive answer, says Olivia S. Mitchell, professor of
insurance and risk management at Wharton and executive director of the school’s
Pension Research Council. Some studies, including one of her own, suggest
Americans are not headed for the old-age catastrophe that many predict. But key
factors, like the future health of Social Security, are impossible to handicap.
“It’s just a brutally difficult problem,” she notes.
The recent debate involves the conflicting results that can be obtained with
different forms of computerized financial calculators used to figure how much a
household needs to save for retirement. Laurence J. Kotlikoff, economics
professor at Boston University, argued in a recent paper titled “Is Conventional
Financial Planning Good for Your Financial Health?” that the simple calculators
in wide use can easily overestimate a household’s annual retirement costs by
10%. For a 40-year-old couple with a $72,000 annual income, this could lead the
program to recommend annual savings of nearly $12,000 when $1,400 would be
enough, he says, adding that financial services firms use these calculators to
pump up sales.
Static vs. dynamic inputs
The most widely used financial calculators found on the Internet and in
software for consumers rely on a static set of inputs. In real life, these
things fluctuate. Or, as Wharton professor of insurance and risk management Kent
Smetters notes, in many cases the simple calculators use “pure rules of
thumb—and the rules of thumb are in error.” The basic web calculators typically
assume stocks will return 8% a year like clockwork, that inflation will sit at
3% forever, and that the household’s income will keep pace with rising
prices.
The more complex dynamic financial models being developed by academics try to
account for more variables, as well as the household’s ability to trim spending
and increase income during lean times. While it is not always the case, many
households shown to be saving too little, according to simple calculators, look
to be doing well in the more realistic ones.
But Smetters and others caution that the dynamic calculators have flaws as
well, since they cannot accurately predict the risk that a breadwinner will lose
a job or that Social Security and Medicare benefits will be trimmed.
No one can know for sure how people will fare in the future. That will depend
on people’s life spans, investment returns, inflation, the cost of housing and
medical care, and many other unknowns. But people have to plan as best they can
despite the uncertainties. The standard approach, used by financial planners and
consumer software programs offered online and through financial services firms,
is to figure how much savings it will take to produce a nest egg big enough to
replace 75% to 85% of a household’s pre-retirement income— a figure called
replacement rate.
To do that, these programs look at factors such as current assets and living
expenses, life expectancy, and eligibility for pensions and Social Security. The
software typically assumes investments like stocks and bonds will perform as
they have in the past and that annual income will grow at a given rate. Thus, it
is simple math to say how big a sum one would need at the start of retirement to
generate enough income to live for the next 20, 30, or 40 years. And it’s easy
to figure how much has to be saved each year at a given rate of return to
accumulate that sum in time. “What most of them do is think about some [time]
horizon and how to end up with some pile of money at the end of that horizon,”
states Nicholas S. Souleles, professor of finance at Wharton.
But the standard 75% to 85% replacement rate is a shortcoming, says Mitchell,
noting that such figures are “essentially numbers made up out of thin air. It’s
difficult to forecast what your spending objectives will be going forward. Even
if one can predict spending needs at age 65, one does not know whether expensive
nursing home care will be needed at 85,” she says, adding that “50% of people
live longer than their life expectancies. If I’m still here, I still want to
consume.”
Moreover, a person earning $20,000 a year when the calculator is used the
first time may be earning $80,000 a year on the eve of retirement decades later,
according to Mitchell. The proper replacement rate, the amount needed to live
adequately in retirement, clearly would be more than 75% of $20,000, but it
might not be 75% of $80,000. It might be somewhere in between.
Because things can go wrong— the stock market could tank, a job could be
lost, or inflation could spike—a person using a static calculator is likely to
build in a margin of safety, aiming for a larger nest egg just in case, Souleles
says. That requires more saving each year before retirement. “It’s going to
force you to be a little conservative,” he notes.
But in real life, the household may well find ways to adjust to jolts like a
stock market downturn. By cutting back spending or taking on overtime or another
job, the household can increase annual savings and keep on track. Mitchell says
her studies have shown, for example, that many people can cut their retirement
funding shortfalls in half simply by working to age 65 instead of 62.
These are the kinds of adjustments the dynamic models try to take into
account, Souleles says. In addition, some consider the user’s occupation,
assessing whether income is likely to rise steeply or not, and whether periods
of unemployment may occur. “What the dynamic models do is they acknowledge you
have some control in the interim,” he says. “You can start responding to events
as they occur…. There are spending and saving decisions that are made each year,
and there is a decision about how hard to work each year. These allow someone to
respond to bad events.”
An example from the past
In fact, this kind of adjusting is found in the historical evidence.
Karl Scholz, an economics professor at the University of Wisconsin at
Madison, and two colleagues used a sophisticated dynamic calculator to look at
the saving and spending patterns among more than 7,700 households headed by
people born between 1931 and 1941. The dynamic calculator figured the financial
resources each household would need to maintain its actual spending level, or
consumption, in retirement. Then the researchers looked at what the households
had actually saved and could expect to receive from investment income, Social
Security, pensions, and other sources.
“We find that over 80% of the … households have accumulated more wealth than
their optimal targets,” the researchers wrote in their 2006 paper, “Are
Americans Saving ‘Optimally’ for Retirement?” Moreover, they added, “For those
not meeting their targets, the magnitudes of the deficits are typically
small.”
But will baby boomers and later generations share the experience of those
born from 1931 to 1941? Scholz and his colleagues concede that “we need to be
careful in generalizing our results … to younger households.”
Among the risk factors they and others point to are the hazards facing Social
Security. In addition, today’s workers, and future ones, are far less likely
than those in the study to have traditional pensions. The adults Scholz looked
at had mean annual incomes just short of $36,000. To maintain their standard of
living throughout retirement, they could count on $106,000 from pension
benefits, $108,000 from Social Security, and $226,000 from other assets such as
investments and home equity.
Mitchell has studied baby boomers for a book to be published this summer,
finding that as a whole, this group appears to be in fairly good financial
shape. But the broad numbers conceal wider extremes than are found in older
groups she studied. Women, non-whites, and people with little education are at
much greater risk of coming up short in retirement, she notes.
Relying too much on calculators
Kotlikoff’s paper argues that static calculators used by four major mutual
fund companies are really marketing tools meant to scare users into buying the
companies’ products. (In addition to his position at Boston University, he is
president of Economic Security Planning, a firm marketing a dynamic calculator
to individuals and institutions.)
“Their advice is remarkably simple, geared, as it is, to speed households
through the planning process in a matter of minutes and quickly reach the
purchase page,” he writes. He adds that the advice produced by the four
companies’ calculators “leads to dramatic over-saving thanks to
retirement-spending targeting mistakes ranging from 36% too high to 78% too
high.”
Have the financial services firms rigged their calculators to encourage
unnecessary investing? Souleles does not think so. “I’ve seen no evidence there
is a deliberate bias,” he says, noting that static calculators originated in the
academic world. The problem arises, he says, when users take the static
calculator’s results as gospel rather than as one planning tool among many.
“There are limitations in this class of models on the Web,” Souleles says.
“There are more elaborate models out there, but it’s difficult to figure how to
bring them to the public.” It can take hours to properly set up a dynamic model
for one household, and it can involve considerable financial education in the
process. Static calculators can be used in minutes.
Most retirement planning aims to achieve “consumption smoothing,” a standard
of living in retirement comparable to what went before, Kotlikoff observes.
Static planners thus begin by asking the user to tally the current cost of
living. But these planners do not examine whether that can realistically be
sustained for a lifetime. If a household is living beyond its means, the
calculator will assume very high retirement needs and demand an excessive amount
of savings, he says. Facing impossible savings demands, some people will give up
and others will try to close the gap with investments that are too risky.
Kotlikoff argues that if a typical household of modest means overestimates
its cost of living in retirement by 10%, it will have to save so much that its
current annual expenditures would have to be reduced by 30%. Some dynamic
calculators, he says, attack the problem by looking at a much wider array of
factors, ranging from the household’s state of residence and tax brackets to
things like plans for having children, vacation home purchases, and possible
one-time financial events such as inheritances. While a static planner typically
assumes cost of living merely rises with inflation year by year, a dynamic one
recognizes that the mortgage will eventually be paid off, the children will
finish school and leave home, and work-related expenses will fall in
retirement—but that other expenses, such as health care, may rise.
Kotlikoff’s calculator uses Monte Carlo simulations to look at a range of
possible results, such as what happens if the stock market follows various
patterns. It then determines the probability the household will achieve its goal
with a given savings rate. “What’s nice about this is he has a very detailed
treatment of the tax system,” Smetters says, “and that makes it much better than
many standard models.” But he also says that the Kotlikoff model does not give
enough weight to the damage done by possible periods of unemployment. “He’s
probably right that people are saving enough if they don’t factor in that
uncertainty. But that uncertainty is a very major reason people should
save.”
The Kotlikoff model and others like it do indeed improve on the simpler,
static calculators, Mitchell says, but she points out also that Kotlikoff’s
model has shortcomings because it cannot accurately forecast the risk that
Social Security and Medicare benefits will be cut, or that taxes will increase
dramatically to shore up those programs, undermining people’s ability to save
and increasing the cost of living in retirement. “To simply ignore that risk …
is not a sensible thing to do,” Mitchell says.
“The bottom line,” adds Smetters, “is that the traditional wisdom that people
are going to come up short is more right than wrong. As a prudent economist, I
would still say the message has to be that people need to save
more.”
