Friday, February 1, 2008

Retirement Planning and Optimally Saving

This is the popular notion:

    “A long time ago, New England was known for its thrifty Yankees.
    But that was before the baby boomers came along. These days, many New Englanders in their 30s and 40s, and indeed their counterparts all over America, have a different style: they are spending heavily and have sunk knee-deep in debt. . . A recent study sponsored by Merrill Lynch & Co. showed that the average middle-aged American had about $2,600 in net financial assets. Another survey by the financial-services giant showed that boomers earning $100,000 will need $653,000 in today’s dollars by age 65 to retire in comfort—but were saving only 31 percent of the amount needed. In other words, the saving rate will have to triple. Experts say the failure to build a nest egg will come to haunt the baby boomers, forcing them to drastically lower standards of living in their later years or to work for longer, perhaps into their 70s. (Wall Street Journal, Wysocki 1995, A1)”

And here is the contrarians view:

John Karl Scholz (University of Wisconsin–Madison and National Bureau of Economic Research) Ananth Seshadri (University of Wisconsin–Madison) Surachai Khitatrakun (Urban Institute) suggest, in a paper titled “Are Americans Saving ‘Optimally’ for Retirement?" the following:

“We solve each household’s optimal saving decisions using a life cycle model that incorporates uncertain lifetimes, uninsurable earnings and medical expenses, progressive taxation, government transfers, and pension and social security benefits. With optimal decision rules, we compare, household-by-household, wealth predictions from the life cycle model using a nationally representative sample. We find, making use of household-specific earnings histories that the model accounts for more than 80 percent of the 1992 cross-sectional variation in wealth. Fewer than 20 percent of households have less wealth than their optimal targets, and the wealth deficit of those who are under-saving is generally small.”

So who is right? And as I ask in the book, “How could you save too little?” The authors use a stochastic (from the Greek for guess) life cycle model that, it should come as no surprise is what the insurance industry uses when they do actuarial estimates. But that is another book.

The authors look at “precautionary savings and buffer stock behavior” as well as “end-of-life uncertainty and medical shocks”, what they call “the evolution of average effective federal income tax rates over the period spanned by our data” and “realistic expectations about earnings; about social security benefits, which depend on lifetime earnings; and about pension benefits, which depend on earnings in the final year of work.”

Using that info they then began “calculating optimal life cycle consumption profiles.” They were also concerned with “he timing of earnings shocks can cause optimal wealth, which can “vary substantially, even for households with identical preferences, demographic characteristics, and lifetime income.”

And based on that, they wrote, “We find that over 80 percent of households have accumulated more wealth than their optimal targets.”

To make this claim, they offer the following as way of quantifying that statement. “Households typically maintain living standards in retirement by drawing on their own (private) savings, employer-provided pensions, and social security wealth.” Private savings is described as “housing assets less liabilities, business assets less liabilities, checking and saving accounts, stocks, bonds, mutual funds, retirement accounts including defined-contribution pensions, certificates of deposit, the cash value of whole life insurance, and other assets, less credit card debt and other liabilities. It excludes defined-benefit pension wealth, social security wealth, and future earnings.”

In short, and you can read the entire paper here, we fail to calculate what we have in assets, our ability to accumulate wealth over the course of our working careers, and our changing life style habits which could allow us to downsize quite effortlessly, giving us access to accumulated wealth equity in our homes.

Key is to this savings is keeping debt manageable and low as you enter the waning years of your working career.

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