I just finished reading the book Spend ‘Til the End: The Revolutionary Guide to Raising Your Living Standard–Today and When You Retire by Burns and Kotlikoff. One of the main themes of the book is consumption smoothing, which is an economic theory where the primary goal of financial planning is to avoid abrupt changes in one’s standard of living.
This can actually be a very controversial goal, because it may ask you to borrow money or even stop saving at times, in order to maintain a constant standard of living. Here is an illustration of this idea taken from the website for ESPlanner, which is a financial planning software package made by Kotlikoff.
Note that consumption smoothing can be very different from what other traditional methods propose. For example, one traditional goal is to replace 75-100% of your current income in retirement. Another generic rule of thumb (which they call “rules of dumb”) might be to simply save 10-15% of your annual income. The authors argue that these one-size-fits-all approaches can greatly overestimate or underestimate the amount of saving one’s family needs to do, leading to the dreaded “standard of living disruption”:
As far as they are concerned, both scenarios are equally bad. Undersavers might die broke. Oversavers are misers and compared to the mentally insane.
Replacement Rates Are Stupid, But Is Smoothing Better?
Now, I would agree that those 5-minute retirement calculators like Fidelity’s MyPlan Calculator or T. Rowe Price’s Retirement Income Calculator can be really off.
For example, Fidelity’s calculator assumes I will need 85% of my pre-retirement income in retirement. But what if my kids are grown up and we’ve already paid for college tuition? What if our house is paid off? What if it isn’t? All these things change what income we need. Look at us – I’ve already calculated that our total non-housing expenses are around $30,000 year – this is less than 15% of our current combined income. An 85% replacement rate would inflate our nest egg target by millions of dollars!!
So yes, inflexible replacement rates are stupid, but I don’t know if consumption smoothing is that much better. I would use ESPlanner, but it costs $200. It is plugged so much in the book that I feel like book buyers should have gotten a free 30-day trial at least to play with it. But I’m betting that even with the smoothing approach, the software will simply say something like “you can maintain a maximum spending standard of $80,000 every year.” Still much more than I need to spend to be content.
I would rather have each household try to estimate their own spending needs from the ground up, and not just spend what some software program tells you to spend. What makes you happy? What are your priorities? What is enough? Then, find a way to create that income.
Predicting The Future
Here’s the problem with all these future calculators. Any time you extrapolate 30 years into the future, any slight change in inputs can throw things way off. Let’s say you think your investments will average 8% returns annually. What happens if it’s only 6%? You estimate inflation at 3%. What if it’s 4%? What if you are 60% stocks/40% bonds, nearing retirement, and your stocks drop 40% in less than a year (*ahem*)? Finally – what about jobs? People switch jobs, careers, geographic locations. Income isn’t so predictable either.
With all this uncertainty, having a calculator tell me I can spend $68,644.55 this year and every year after that just doesn’t seem right.
I don’t know about you, but I see running out of money as a lot worse than ending up with too much. Accordingly, I simply view retirement (financial independence, whatever) as a goal to be reached as soon as possible, while still enjoying life along the way.
Positive Consumption Slope?
Just a thought, but I don’t know if I would want a constant standard of living anyway. I would rather having a slowly improving standard of living, so that life is (supposedly) getting a little better as I go.
Still, consumption smoothing is an neat concept, and the book goes on to extend it into a number of other interesting examples. More to come…