Spend less and save more is recipe for retirement

Rob Arnott: Spend less and save more is recipe for retirement

By Rob Arnott
Published: June 14 2008 04:24 | Last updated: June 14 2008 04:24
Oil
prices and fears about recession, inflation and falling earnings are
suddenly on everyone’s minds. We’ve covered those in past months. But
what’s been pushed off the front page that is important to everyone?
The Ed McMahon problem.“If you spend more money than you make, you know what happens,” McMahon said recently on CNN’s Larry King Live,
explaining why he’s losing his home. To those of us in the baby boom,
McMahon was a fixture of our formative years, as was his ebullient,
“Heeeeeeere’s Johnny!” He made millions, back when a million dollars
was serious money. How could he run out of money?There are three
issues, amply illustrated by McMahon. We’re living longer; we’re
spending too much; and we’re saving too little. Since outliving our
savings often involves all three, and since a shorter lifespan isn’t an
option that most of us care to consider, let’s drill down on the other
two.First, the easier of the two, savings. You can’t invest what
you haven’t saved. Which countries have enjoyed the fastest gross
domestic product growth in recent decades? Japan in the 1970s and
1980s. China in the 1990s and 2000s. What’s their most significant
shared attribute? A high savings rate.If you are likely to live
80 years, as is increasingly the norm, and want to retire comfortably
at 65, what’s the plan? The first 20-25 years is your childhood and
education period. So, you have just 40-45 years to save enough to last
you 15 years. If you don’t think about retirement until 40-45, you have
20-25 savings years. Perhaps you don’t get serious about it until
50-55, so you then have 10-15 years to save enough to last you 15
years. Ouch. Then, like McMahon, we don’t check out at 80, but live
longer. So that 15-year plan becomes a 20- or 30-year plan.We
all understand the problem. But, you cannot afford to save right now?
Stop right there. How many friends do you have who make 75-80 per cent
of what you make? Is their lifestyle so wretched? Just emulate it.
Then, you can save 20-25 per cent of your after-tax income – each and
every year.If you are locked into your current spending pattern,
then cap it. Stop right where you are, until your income is 25 per cent
higher. This will probably take about five years, if you are working
reasonably hard.The hard part is managing our spending. If
you’re talking to two financial advisers, and one tells you that you
can spend 8 per cent of your assets every year, while the other
counsels 4 per cent, who will you want to work with? I propose a much
simpler paradigm. Look at actuarial tables to find your life
expectancy. Divide your liquid assets (stocks, bonds and cash) by that
figure, and don’t spend your savings by more than that sum. Do not
include your house, which you can’t spend. I’m about to turn 54.
Actuaries say my life expectancy is another 25.1 years. So, if I have
$1m in liquid assets, I can retire today ... if I’m willing to live on
$765 a week.Don’t we want to allow for an 8 per cent return on
our assets, which seems to be a common assumption, to plan our
spending? No, for several reasons.First, net of inflation and
taxes, our personal investment returns will be dismayingly close to
zero. Our 5 per cent on bonds loses roughly 2 per cent to state and
local taxes and another 2-3 per cent to expected long-term inflation.
The after-tax picture for stocks is only slightly better.Second,
the cost of living keeps getting higher. Over that 25-year life
expectancy, will costs be the same as they are today? No. In 1983, I
could book a very nice hotel room in Manhattan for $160, and have a
superb meal for two – including a first growth Bordeaux plus tax and
tip – for a like sum. The comparable room and meal today are $800 each.
If we ignore inflation, we’ll have to lower our lifestyle substantially
over time.Third, spending returns before they’ve been earned is
dangerous. Last month, I addressed this issue with regard to corporate
pension return assumptions. Spending the money after it’s been earned
is far, far safer. Ramping up our lifestyle, with real after-tax
returns above zero, is easier than ratcheting down if we fail to earn
the 8 per cent we were expecting.Finally, we should keep working
until that ratio of liquid assets to “years left” is more to our
liking. Retiring at 65 made sense when two out of three people didn’t
reach 80. It doesn’t make sense today, unless we’ve saved like the
Japanese and Chinese.
The writer is chairman of Research Affiliates.
arnott@rallc.com

Copyright The Financial Times Limited 2008


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