The conventional wisdom about retirement may be worth re-examining, say two financial-planning mavericks.
In their recently published book, "Spend 'til the End: The Revolutionary Guide to Raising Your Living Standard (Today and When You Retire)," Laurence Kotlikoff, a Boston University economics professor, and Scott Burns, a financial columnist whose work appears on MSN Money, use retirement-planning software to systematically test and often debunk the collective wisdom of financial planners.
Here are three of the many retirement myths that Kotlikoff and Burns say didn't withstand the scrutiny of ESPlanner, software that Kotlikoff helped develop.
Myth No. 1: You should replace a certain percentage of your income in retirement.
The financial-services industry typically tells you to replace 70% to 85% of your working income in retirement. For example, if you make $70,000 a year, you would subtract an estimated $14,073 for taxes, $2,421 for retirement savings and $1,975 for work expenses, and end up with $51,531 annually that needs to be replaced in retirement. That works out to 74%. It's a quick and easy calculation that Kotlikoff and Burns say is often much too high.
"This replacement rate was developed by the industry in order to promote sales of their mutual fund products and is inappropriate for most households," Kotlikoff says.
Traditional replacement rates assume that all other expenses (except for work expenses and retirement savings) stay the same in retirement. But spending on children stops when (and if) they move out of the house, college tuition payments end, mortgages can often be paid off and you can downsize to a smaller home. They also ignore new expenses such as taking care of parents or a country club membership for golf in your newfound leisure time.
Instead, Kotlikoff advocates what he calls "consumption smoothing." That means spending more in your working years, when there are more mouths to feed, and less in retirement, when it's just you and your spouse or perhaps just you alone.
"The spending target that is the right one is going to be the one that guarantees the same standard of living as the one before retirement," Kotlikoff says. So, say you spend $59,759 a year when two kids are at home. That amount can drop to $47,299 when the first child leaves and $33,006 when the second is gone -- and even more when the mortgage is paid off, Kotlikoff says.
"You don't want to squander your youth worrying about retirement," he says. "The goal is to have a smooth living standard; it's not to be a billionaire when you are dead."
Myth No. 2: You should hold a combination of stocks and bonds in your 401k.
Yes, all your financial assets should be diversified, but that doesn't mean your 401k itself needs to be. If you have both tax-deferred retirement accounts and regular investment accounts, you should hold stocks in the regular accounts and bonds in retirement accounts to reap the best tax rewards, Kotlikoff and Burns argue. Equities pay their returns as capital gains and dividends, which are taxed at a 15% rate or lower, depending on income. Bonds pay out interest that is taxed at the income tax rate, as high as 35%. But everything you accrue in a tax-deferred retirement account -- be it capital gains, dividends or interest -- is taxed as income at the higher rate when you take the money out.
Let's say a 40-year-old has $300,000 in regular assets invested in Treasury inflation-protected securities (TIPS), a type of bonds, and $300,000 in a 401k, individual retirement account or other tax-deferred retirement account holding a mix of stocks, to which he adds $10,000 a year. Once the person starts drawing down the savings in retirement, the accounts would be expected to produce annual retirement income of $92,906. But Kotlikoff and Burns say that by flipping the accounts so that the tax-advantaged account is composed of bonds and the regular account of stocks, the same person could raise his retirement income to $99,341, a 6.9% increase.
The exception to this rule, the authors say, is if you need money for immediate expenses, such as taking care of older relatives or making a major purchase. "You want to have some money that is safe to deal with emergencies," Kotlikoff says.
Myth No. 3: A broker can help you get higher returns.
Although many money managers vow to beat the market, the odds are against it.
"About 80% of mutual fund managers underperform the market," Kotlikoff says. "In addition to buying securities that are risky, you are buying a money manager who is risky, and you are also paying a high price."
Brokerage fees can take a hefty bite out of retirement plans. A reasonable expense ratio for investments is 0.1%, Kotlikoff says. The typical investment brokerage account charges 2% a year in fees. For a portfolio yielding 5% after inflation, that reduces annual returns by 40%.
For example, a 30-year-old employee saving 6% of his $50,000 annual salary in a 401k, with a 50% employer match, might accumulate $505,474 by age 66 (assuming a typical 60-40 split between equities and fixed income and an annual return of about 8%) in an ultra-low-cost plan with an annual cost of just 0.03%. But if you subtract the typical 2% annual brokerage fees, the same person would have only $340,653 at age 66, the authors say.
"You can do all this stuff on your own without paying high fees," Kotlikoff says. "Just invest in index funds for stocks and TIPS for bonds."