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Retirement Planning Software:Behavioral and Demographic
Perspectives
John Turner
Senior Policy Advisor
AARP
October 26, 2006
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Disclaimer
• This presentation does not necessarily represent the views of AARP.
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Regulating Advice
• In recognition of the increasing importance of financial advice provided by computer programs, the Pension Protection Act of 2006 regulates the investment advice provided by computer programs to pension participants.
• Among other things, it requires that models apply generally accepted investment theories.
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Kotlikoff’s Paper
• Kotlikoff examines whether conventional financial planning software provides useful information to workers, or whether the software, even when used properly, provides erroneous results.
• He compares conventional software to his own software, which he finds to be superior.
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Kotlikoff’s Contribution
• Kotlikoff focuses on the computational challenge for financial planning software posed by consumption smoothing.
• His main criticism of traditional financial planning software is that it is based on the participant choosing a spending target in retirement, which he argues is extremely difficult to do accurately.
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Life-Cycle Model Under Attack
• Kotlikoff’s critique of the difficulty of picking a target level of consumption in retirement also is a critique of the accuracy of the predictions of the life-cycle model.
• He argues that “setting spending targets that are consistent with consumption smoothing is incredibly difficult to do, making large targeting mistakes almost inevitable.”
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Empirical Evidence
• He argues further that empirical studies of savings show that vast numbers of households either save too little or too much.
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Large Errors
Kotlikoff measures planning errors by the disruption of consumption in retirement, finding that retirement consumption easily could be too large or too small by 30 percent.
It would be useful to assess the effect on lifetime utility of these errors.
If workers were to oversave for retirement, the loss of utility earlier in life would be offset to some extent by the higher utility provided by the higher consumption in retirement.
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Replacement Rates
• While Kotlikoff does not use the replacement rate concept with his planning software, that concept is widely used in U.S. policy circles as a measure of the adequacy of retirement income.
• Replacement rates are often defined as retirement income in the first year of retirement divided by the annual amount of an individual’s income just prior to retirement.
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Rule of Thumb
• Kotlikoff argues that it is exceedingly difficult to determine your target consumption level in retirement, which is why people need his software.
• Behavioral economics teaches that when people face a decision that is conceptually difficult, they tend to rely on rules of thumb to simplify the decision-making problem.
• In this context, a replacement rate may be a useful concept as a simple rule of thumb.
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Kotlikoff’s Replacement Rate
• Although Kotlikoff does not use the replacement rate concept in his software and criticizes the replacement rates used in other retirement planning software, a replacement rate can be calculated from his paper.
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Replacement rate = 40%
• He analyzes the finances of a couple, both are age 40, with children ages 7 and 10, and total family income of $125,000.
• He finds that the optimal total consumption in retirement assuming that both husband and wife are alive is $50,139 in constant dollars.
• This produces a replacement rate relative to income at age 40 of 40 percent.
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Low Replacement Rate
• Several factors explain his low replacement rate for consumption smoothing in retirement:─Paid off mortgage─Children out of college─No longer saving for retirement
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Demographic Assumptions
• This low replacement rate may also be an artifact of the assumption that both husband and wife live to age 95.
• That assumption is made to assure that people will not run out of money.
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Replacement Rate Comparisons
• AON Consulting and Georgia State University have calculated target replacement rates ranging from 75% to 86%, depending on family income.
• The Society of Actuaries has recommended a replacement rate of 90%, based in part on the expense of retiree medical care and long term care.
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Reasons for High Replacement Rates
• In some studies, high target replacement rates may arise by not taking into account the accumulation of assets and the possibility of spending down assets.
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Other Financial Planning Software
• In evaluating the advice provided by four well-known, reputable financial services companies, Kotlikoff found that because they had substantially higher target replacement rates they all advised dramatic oversaving, in comparison to what would be needed to maintain a constant level of consumption.
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Replacement Rate Conclusions
• Kotlifkoff’s finding concerning the optimal level of consumption (and implied replacement rates) makes an important contribution to our understanding of financial advice that American workers receive.
• His paper challenges not only standard financial planning software, it challenges the replacement rates used in standard financial planning.
• Further work needs to be done to reconcile the different results.
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Rules of Thumb
• A low tech alternative to financial planning using dynamic programming is to use rules of thumb.
• An enhanced set of rules of thumb could provide useful, albeit imprecise, guidance for people planning for retirement.
• In that vein, I tentatively propose four.
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(Provisional Rules)
• Rule 1. You can expect to live x (2 or 3) years longer than your parent of the same gender.
• Rule 2. You can consume x (5 or 6) percent of your assets every year in retirement as a conservative rule for not running out of money.
• Rule 3. If you don’t have a defined benefit pension but only a 401(k) plan, your pension and retirement savings need to be x (7 or 8) times your annual income if you plan on retiring at age 62.
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Rule 4?
• Rule 4. You should try to replace x percent of your income measured in the period shortly before you retire.
• Is 40% the right number?
• For families whose children are out of college but who still have a mortgage, that strikes me as too low.
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Demographic Literacy
• The life cycle theory assumes that workers accurately assess their life expectancy.
• Rational workers would undersave if they underestimate their life expectancy.
• With improvements in life expectancy, workers may tend to underestimate life expectancy.
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Life Expectancy Expectations
• Several studies have examined life expectancy expectations.
• Some studies have shown a fairly sizable degree of underestimation of life expectancy, but other studies have not found that result.
• The evidence is mixed and further work is needed to reconcile the findings.
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Heterogeneity
• There are very large differences in life expectancy between identifiable groups.
• For example, there are large differences between Asian females and African American males living in inner cities.
• This heterogeneity may be another source of problems with the use of financial planning software that picks a single age of death for everyone.
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Conclusions (1)
• Kotlikoff’s paper provides an important contribution by challenging traditional approaches to financial planning software and financial planning.
• His work points out wide differences in recommended levels of consumption and recommended replacement rates.
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Conclusions (2)
• An implication of Kotlikoff’s work is that the replacement rates used in traditional financial planning software and in financial planning generally are much too high.
