The Experts Offer Their Opinions On The Best Road To Retirement
Monday, May 26, 2008PAUL KANGAS: So figuring out if you're financially ready to retire may not be easy, but it's still important to try. And joining us are two experts with different views on how to do that: Cecil Hemingway, retirement practice leader for Aon Consulting, a division of Aon Corporation that advises companies on human capital matters and Laurence Kotlikoff, economics professor at Boston University and co-author of the new book, "Spend 'til the End." He also heads a company that sells retirement planning software. Cecil, let's begin with you. For many years, your firm has set retirement replacement ratios. Those take pre-retirement income levels and figure the percentage that average people need to maintain their living standards in retirement. Aon has just come out with the 2008 replacement ratios. What do they show?
CECIL HEMINGWAY, US RETIREMENT PRACTICE LEADER, AON CONSULTING: Hi, Paul, yes, the replacement ratios vary quite a bit by pay levels, so you do have to look at various pay levels and what we show is that for folks making about $60,000 a year, they would need about 78 percent of their pre- retirement income to maintain their living standards into retirement. That number doesn't go up as you go to about $90,000 of pre-retirement income and so for somebody with an income pre-retirement of about $150,000 a year, the replacement ratio target goes up from 78 to 84 percent. And you have to look below the surface a little bit. A lot of that comes from Social Security for the lower paid folks, about 46 percent. And then when you go to the higher-paid person making $150,000 a year, Social Security replaces only about 23 percent.
KANGAS: Now, Laurence, you are a critic of income-replacement formulas for retirement, including those that are incorporated in many retirement calculators. In your book, you describe this method as financial snake oil and you say that it's dead wrong for most people. Why do you see it as so flawed?
LAURENCE KOTLIKOFF, ECONOMICS PROF., BOSTON UNIVERSITY: Well, these calculations are very primitive. They're only taking in a couple of variables. They're not asking questions like how many kids you have, what college expenses you're going to have, whether you're going to downsize your home, move to Texas and not pay state income taxes. There are just a host of pretty important questions. So it's like going to the doctor and having a two-second checkup and then getting a prescription.
KANGAS: Cecil, you believe there is value in the income replacement- ratio method, but would you agree that people should not rely on it solely in determining how much to set aside for retirement?
HEMINGWAY: Yes, Paul. I think it's interesting to note that in doing the replacement income ratio that Aon Consulting has been doing for so many years with Georgia state, we actually do what Larry suggests, but in a general sense. We try to understand what the spending needs are after retirement; we reflect changes in tax status and the fact that you no longer have to save. We also use the Bureau of Labor Statistics' consumer expenditure data to reflect the fact that your spending patterns after retirement are different. So I think we need to be careful to not necessarily take something which can be quite useful and label it and then summarily dismiss it. The way I think about it is retirement is a journey and I would agree with Larry that if we could all have a GPS that journey would be very precise and wonderful, but certainly many of us don't have a GPS or don't have the money to buy the GPS, so a plain, old-fashioned compass that tells where north is can get us much further than just simply being lost in space.
KOTLIKOFF: The problem here is that the compass is pointing in large cases in the wrong direction. You're telling people with this replacement rate calculation in many cases to save five times more than they should. And then this thing is being then used to induce people to hold risky assets to raise the probability of making a target that's too high. So if you actually take households, actual households and run them through the right software, find out what they should be saving and then compare that with these income replacement targets, you find out they're off by a factor of five. So it's not small mistakes here; it's really pointing south when you should be going north.
KANGAS: Finally, gentlemen, let me ask you both, considering how complex it is to determine a person's financial readiness for retirement, is it better to leave this task to a financial professional?
KOTLIKOFF: I would say no. The right software is completely easy to use. You enter standard -- you know, answer very simple questions like what your mortgage is, what your kids' ages are, things that aren't included in this replacement rate calculation and then in three seconds you get an answer. So it's actually not complex; it's actually very simple these days to get the right answer.
KANGAS: Briefly, Cecil, your rejoinder?
HEMINGWAY: There's a lot of assumptions here, and I do think just software has a very great purpose, but at the same time it is very important -- these are important decisions and I think having a professional to help you and maybe use the software as a tool to supplement the professional advice is probably not a bad idea.
KANGAS: Gentlemen, I want to thank you very much for your different views on this important subject. My guests, Lawrence Kotlikoff of Boston University and co-author of "Spend 'til the End" and Cecil Hemingway, leader of the retirement practice at Aon Consulting.
