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Make your standard of living the basis for all financial planning

Social Security rules are complicated and change often. For the most recent “Ask Larry” columns, check out maximizemysocialsecurity.com/ask-larry.

Editor’s Note: The following is adapted from Larry Kotlikoff’s earlier article in the Journal of Financial Planning. His Social Security Q+A will return next week, so keep the questions coming.

Imagine a 35-year-old California couple, the Joneses, making $100,000 a year with two children, ages 3 and 5. How should a financial planner help them prepare for their future?

The couple has no assets apart from a $400,000 house with a 20-year, $300,000 mortgage, with monthly payments of $3,000. Property taxes, insurance and maintenance amount to $7,500 a year. The couple is covered by Social Security, plans to spend $25,000 a year in today’s dollars for four years helping their children pay for college, and anticipates hefty hikes in Medicare’s Part B premium. If they need nursing home care, the couple intends to do what most other households of their means do: rely on Medicaid. Finally, the couple is assumed to earn 3 percent above inflation each year on its investments and to plan for the worst-case scenario of living to 100.

Conventional financial planning would encourage their household to put its saving on autopilot and force its living standard to adjust each year to annual changes in its income and off-the-top expenses. A better strategy would protect their living standard.

The Joneses should adopt an economics (read common sense) strategy to spend more when there are more mouths to feed and less when there are fewer. This is called consumption smoothing because it will smooth their living standard over time.

In the saving context, this means moving resources from good times, when one is working and earning money, to bad times, when one is retired and earning nothing. In the insurance context, it means moving money from good times, when the house hasn’t burned down or the principal earner hasn’t died, to bad times, when these events happen. And in the investment context, it means diversifying one’s resources so that there is something to eat not only when the stock market booms, but also when it crashes.

Under this plan, to smooth their household’s living standard per person, the Joneses should spend $41,395 when both children are at home, $35,405 after the first child heads to college, and $28,886 after the second child leaves home. Once the second child graduates, and the couple gets out from under its borrowing constraint from the mortgage and college expenses, their spending rises to $30,345 a year and remains there until age 100, assuming each spouse lives that long. The household’s living standard per person is $18,054 until the children are out of college, and $18,965 thereafter.

How To Smooth Your Spending

Understanding this economic approach and actually implementing it, however, are two different things. Take deciding how much to spend today. If you are trying to smooth your living standard over time, you’ll need to know what your current spending will leave you with the next period and how those resources you bring into the next period will affect the following period’s spending, which will affect spending the period after that, and so forth into the future.

Stated differently, knowing what you should do today requires a game plan for tomorrow. You can use what economists call dynamic programming to tackle seemingly intractable sequential problems where what you do next depends on what you do now.

Imagine, for a moment, that you’ve got certain errands to do before catching a plane. Deciding when to head to the airport provides a simple example of dynamic programming, which most of us would instinctively use in our everyday lives.

We would solve the problem backward, starting with the plane’s departure time, subtracting an hour to check in and go through security, subtracting the time needed to go from the office to the airport, subtracting the time needed to go from the bank to the office, and then subtracting the time needed to go from home to the bank. The end result would be the time to depart from home.

The alternative to this dynamic programming approach is to simply try a range of different potential times at which to leave the house and keep adding in the amounts of time for the different tasks and then see whether that starting time leaves us arriving too early or too late to catch the plane. Such a method will eventually get us to the right answer, but take forever doing so.

Conventional financial planning establishes spending targets through the same sort of guesswork — only the costs are higher because instead of missing your plane, you could be drastically lowering your standard of living if you use this approach. Even small targeting mistakes can make a major difference in saving recommendations. Why? Because the targeting mistakes are being applied to all 40-or-so years of a household’s potential retirement and a large number of small mistakes adds up.


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When retirement spending targets are set too high — higher than the appropriate living-standard-smoothing level — households are told to save too much and spend too little before retirement. When the targets are set too low, households are told to save too little and spend too much before retirement. Either way, when the household reaches retirement age, its living standard will change abruptly — its consumption will be disrupted rather than smoothed. Targeting mistakes of even 15 percent can readily induce 30 percent disruptions in living standards, pre- and post-retirement.

Working backwards from the flight time (or using dynamic programming) to smooth (to the extent possible) a household’s living standard delivers a lifetime spending plan. These recommended spending amounts constitute the right household spending targets — not just for retirement, but for each year before retirement. Associated with this life-cycle spending plan is a life-cycle saving plan.

Why Conventional Planning Fails

Using the replacement rate methodology that conventional financial planning relies on is highly problematic for several reasons.

First, these calculations assume that a household’s spending after retirement will be precisely the same as its spending before retirement. This is, to put it mildly, a strong assumption given that the pre-retirement spending being measured includes all household outlays, be they on consumption, mortgage payments, support for children, education, medical bills, and so on.

Second, the replacement-rate method ignores new spending needs in retirement. Omitting Medicare Part B premiums and other retirement-specific expenditures, the replacement rate method understates the household’s future spending needs and, therefore, what it needs to save.

Third, the replacement rate presumes that the household’s demographic composition will remain constant throughout retirement; that is, it ignores the fact that children will leave the household and that one spouse may be significantly younger than another.

Fourth, the replacement-rate method assumes that the household’s current saving behavior is consistent with consumption smoothing — that is, with maintaining the household’s underlying living standard per person through time. There is no reason to believe this is the case. Ironically, if households are already saving the appropriate consumption-smoothing amounts, they have no need for a replacement-rate target. But if they are not, the replacement-rate methodology will produce the wrong replacement rate because it will use actual saving (that is, the wrong saving amount) in calculating the rate.

Can You Really Save or Invest Too Much?

Conventional methods, as a rule, appear to recommend much more saving and insurance than is economically justified. But can households really save and insure too much given life’s uncertainties?

One of the risks that an economics approach considers, which is easily ignored, is the risk of spending too little when young and dying before having had a chance to spend too much when old. This risk of squandering one’s youth rather than one’s money is fully incorporated in the lifetime balancing act that is proper consumption smoothing.

Over-insuring is also an economics no-no. The goal of insurance is to equalize one’s living standard across good and bad times, not deprive oneself when bad things don’t happen in order to live at a much higher level when they do. This is why none of us buys fire insurance for five times the value of our homes. The same logic applies to life insurance. It’s meant to insure one’s prior living standard, not multiply it.

The same danger applies to evaluating investment risk. Households that are given inappropriately high savings goals may be induced to invest in higher yield, but also riskier securities in order to raise the probability of meeting the target. Although it’s true that higher-yield investing can improve one’s chances of success, as so defined, it also can worsen the extent of the downside. In focusing on the probability of meeting the target as opposed to the level to which one’s living standard will fall if one’s assets perform poorly, conventional planning may be inducing excessive risk-taking.

Economics considers what really matters when it comes to risky investing — the level and variability of one’s living standard through time. Such analysis can help one choose how best to allocate one’s portfolio and how rapidly to spend down one’s assets given that portfolio allocation.

Under the economics approach, your asset holdings should not smoothly decline with age, but rather follow a roller-coaster pattern. To be precise, young households should invest a small to moderate share of their financial assets in stock. They should increase this share dramatically in their middle ages. Then they should reduce this share as they approach retirement. Next they should increase the equity share modestly in early retirement, and reduce this share dramatically in late retirement. Also, at any age, they should set their equity share based on their risk aversion.

It All Begins with the Living Standard

Virtually all other personal financial questions begin and end with our living standard. Can we afford the addition? Can we retire in Hawaii? Can we help the kids buy a house? Does converting to a Roth IRA make sense? Does taking out long-term care insurance beat self-insuring?

When it comes to personal finance, economics keeps one issue front and center: our living standards. Spending, saving, insuring, and investing — all of these decisions boil down to smoothing our living standards, protecting our living standards and making informed, careful gambles to raise our living standards.

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