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  • 1. Retirement Planning Software: Behavioral and Demographic Perspectives John Turner Senior Policy Advisor AARP October 26, 2006
  • 2. Disclaimer <ul><li>This presentation does not necessarily represent the views of AARP. </li></ul>
  • 3. Regulating Advice <ul><li>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. </li></ul><ul><li>Among other things, it requires that models apply generally accepted investment theories. </li></ul>
  • 4. Kotlikoff’s Paper <ul><li>Kotlikoff examines whether conventional financial planning software provides useful information to workers, or whether the software, even when used properly, provides erroneous results. </li></ul><ul><li>He compares conventional software to his own software, which he finds to be superior. </li></ul>
  • 5. Kotlikoff’s Contribution <ul><li>Kotlikoff focuses on the computational challenge for financial planning software posed by consumption smoothing. </li></ul><ul><li>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. </li></ul>
  • 6. Life-Cycle Model Under Attack <ul><li>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. </li></ul><ul><li>He argues that “setting spending targets that are consistent with consumption smoothing is incredibly difficult to do, making large targeting mistakes almost inevitable.” </li></ul>
  • 7. Empirical Evidence <ul><li>He argues further that empirical studies of savings show that vast numbers of households either save too little or too much. </li></ul>
  • 8. Large Errors <ul><li>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. </li></ul><ul><li>It would be useful to assess the effect on lifetime utility of these errors. </li></ul><ul><li>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. </li></ul>
  • 9. Replacement Rates <ul><li>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. </li></ul><ul><li>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. </li></ul>
  • 10. Rule of Thumb <ul><li>Kotlikoff argues that it is exceedingly difficult to determine your target consumption level in retirement, which is why people need his software. </li></ul><ul><li>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. </li></ul><ul><li>In this context, a replacement rate may be a useful concept as a simple rule of thumb. </li></ul>
  • 11. Kotlikoff’s Replacement Rate <ul><li>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. </li></ul>
  • 12. Replacement rate = 40% <ul><li>He analyzes the finances of a couple, both are age 40, with children ages 7 and 10, and total family income of $125,000. </li></ul><ul><li>He finds that the optimal total consumption in retirement assuming that both husband and wife are alive is $50,139 in constant dollars. </li></ul><ul><li>This produces a replacement rate relative to income at age 40 of 40 percent. </li></ul>
  • 13. Low Replacement Rate <ul><li>Several factors explain his low replacement rate for consumption smoothing in retirement: </li></ul><ul><ul><li>Paid off mortgage </li></ul></ul><ul><ul><li>Children out of college </li></ul></ul><ul><ul><li>No longer saving for retirement </li></ul></ul>
  • 14. Demographic Assumptions <ul><li>This low replacement rate may also be an artifact of the assumption that both husband and wife live to age 95. </li></ul><ul><li>That assumption is made to assure that people will not run out of money. </li></ul>
  • 15. Replacement Rate Comparisons <ul><li>AON Consulting and Georgia State University have calculated target replacement rates ranging from 75% to 86%, depending on family income. </li></ul><ul><li>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. </li></ul>
  • 16. Reasons for High Replacement Rates <ul><li>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. </li></ul>
  • 17. Other Financial Planning Software <ul><li>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. </li></ul>
  • 18. Replacement Rate Conclusions <ul><li>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. </li></ul><ul><li>His paper challenges not only standard financial planning software, it challenges the replacement rates used in standard financial planning. </li></ul><ul><li>Further work needs to be done to reconcile the different results. </li></ul>
  • 19. Rules of Thumb <ul><li>A low tech alternative to financial planning using dynamic programming is to use rules of thumb. </li></ul><ul><li>An enhanced set of rules of thumb could provide useful, albeit imprecise, guidance for people planning for retirement. </li></ul><ul><li>In that vein, I tentatively propose four. </li></ul>
  • 20. (Provisional Rules) <ul><li>Rule 1. You can expect to live x (2 or 3) years longer than your parent of the same gender. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
  • 21. Rule 4? <ul><li>Rule 4. You should try to replace x percent of your income measured in the period shortly before you retire. </li></ul><ul><li>Is 40% the right number? </li></ul><ul><li>For families whose children are out of college but who still have a mortgage, that strikes me as too low. </li></ul>
  • 22. Demographic Literacy <ul><li>The life cycle theory assumes that workers accurately assess their life expectancy. </li></ul><ul><li>Rational workers would undersave if they underestimate their life expectancy. </li></ul><ul><li>With improvements in life expectancy, workers may tend to underestimate life expectancy. </li></ul>
  • 23. Life Expectancy Expectations <ul><li>Several studies have examined life expectancy expectations. </li></ul><ul><li>Some studies have shown a fairly sizable degree of underestimation of life expectancy, but other studies have not found that result. </li></ul><ul><li>The evidence is mixed and further work is needed to reconcile the findings. </li></ul>
  • 24. Heterogeneity <ul><li>There are very large differences in life expectancy between identifiable groups. </li></ul><ul><li>For example, there are large differences between Asian females and African American males living in inner cities. </li></ul><ul><li>This heterogeneity may be another source of problems with the use of financial planning software that picks a single age of death for everyone. </li></ul>
  • 25. Conclusions (1) <ul><li>Kotlikoff’s paper provides an important contribution by challenging traditional approaches to financial planning software and financial planning. </li></ul><ul><li>His work points out wide differences in recommended levels of consumption and recommended replacement rates. </li></ul>
  • 26. Conclusions (2) <ul><li>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. </li></ul>
  • 27. Contact Information John Turner Senior Policy Advisor AARP 202-434-3881 [email_address]

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