Not Making It In L.A. On $75K

by: Laurence Kotlikoff

$75K sounds like a great starting salary for a college grad.

It's far above the U.S. median wage.

But given CA's taxes and L.A.'s housing costs, making it in L.A. is no picnic.

But some belt tightening and a spending machine can save the day.

Keeping track of inflation over time is hard even for economists. I recently was talking to a friend's son - I'll call him John Doe - who just graduated from Harvard and is starting a job in L.A. at $75K. That seemed like a lot - far beyond what anyone I knew graduating college received. But then I realized that inflation may have a lot to do with my thinking $75K was high. When I graduated, back in 1973, $75K was the same, in real terms, as $42,700, i.e., 45 years of inflation can make relatively small numbers seem much bigger than they are.

Next I realized that it's been a long time since 1973 and that I don't remember how well one could live back then on $42,700 just as I don't know how well one can live on $75,000, let alone in L.A., on that annual income. So I used my personal financial planning company's spending machine - Smarter Personal Financial and Retirement Planning Software | MaxiFi Planner - to think this through. What I found surprised me. But then I thought of ways that John might salvage his situation.

Here's the resulting short economic story.

Twenty-two-year-old John Doe just graduated Harvard with a job in L.A. Best yet, it pays $75K per year! That’s well above Americans’ median pay. John also landed a great two-bedroom apartment. Yes, it costs $2,000 per month. But rents in L.A. are out of sight.

After signing his lease, John, who majored in economics, decides to compute an annual spending budget. He figures he’ll work till age 60 and hit the beach full time. His job has no retirement plan. Bummer. But, gee, his salary is really high. And, unlike many of his classmates, he has no student debt to pay off. He’s sure he’ll be able to spend at least $3K per month. But then he runs, which does lifetime budgeting. (He first ran across the tool in a high school class on personal finance.) Since John doesn’t want to count on earning more than the current safe rate of return, he assumes he’ll make 1 percent above inflation on his savings. This is close to the current real return on 30-year TIPS (Treasury Inflation Protected Securities).

MaxiFi tells John what he can spend on a discretionary basis each year and keep spending it. Discretionary spending refers to all spending apart from off-the-top spending on taxes and rent, i.e., it’s his annual budget for spending on clothes, food, travel, entertainment, gifts, yoga classes, gym membership, etc.

To his shock, John’s sustainable discretionary spending is a mere $12,217 per year. John can’t believe it. How can a Harvard grad making $75,000 per year for the next 38 years and $28,451 per year in Social Security benefits, starting at 60, have so little to spend?

Here’s the answer: First, John’s maximum age of life is 100. If he lives that long, he’ll end up retired longer than he worked. Second, the $24K in rent eats up a third of his pre-tax income right off the bat. Third, Uncle Sam and the State of California intend to tax John… well, to death. Indeed, 35.35 percent of his per-tax lifetime earnings will go to taxes. Fourth, his cost for Medicare Part B premiums when he retires will start at $6,081 per year at 66 and rise to $15,863 per year (in today’s dollars) at 100 given the history of Medicare premium hikes.

John truly can’t believe his eyes. But MaxiFi’s reports are spot on. He calls home to tell his folks the horrible news: Their Harvard grad with the $75K job is flat broke.

“Mom, Dad, I can spend $12,217 per year, $1,018 per month, and $33.5 per day. If I go to Mickey D’s and buy a 2-sausage burrito breakfast meal, a bacon clubhouse lunch meal with a coke, and a double filet-o-fish dinner meal with a diet root beer (want to watch my weight), it will cost me $11,559.55 per year, $963.3 per month and $31.7 per day. I’ll have hardly enough money to pay for gas, let alone fly home to visit!”

His mother suggests he find a roommate. This drops John's monthly rent in half and almost doubles John’s yearly discretionary spending to $24,217. Next, John's dad tells him that saving in an Individual Retirement Account (IRA) will lower his current and, indeed, lifetime taxes. So, John contributes 5 percent of his annual salary, i.e. $3,750, to an IRA. This helps, but not much. John’s discretionary spending is now $24,283 per year. His sister proposes annuitizing his IRA withdrawals, which he intends to start at 60, via an inflation-indexed annuity policy. This raises John’s annual sustainable spending, but again, not by much, to $24,303 per year. (Annuitizing this young doesn't produce much of a kicker.)

Over a bacon clubhouse lunch meal with a coke, John’s workmate suggests he transfer to the company’s offices in Washington State. His eyes light up. Washington has no state income tax. Moving there (with his roomy) raises his discretionary spending level to $26,737. But this is still far less than he had hoped to spend. He asks his brother, a Boston University grad, what else he can do to raise his sustainable budget. His brother looks at his plan and says, “What? You think you can retire at 60? What college did you attend? Nobody in our generation can afford that luxury.”

Chagrined, John redoes his plan specifying retirement at 67 and contributions to his IRA through age 67. This boosts his discretionary spending to $33,009 annually. Finally, John’s 4th cousin, 7th removed suggests that he file for Social Security benefits at 70, when they will start 24 percent higher than if he takes them at 67. This raises his discretionary spending level to $36,233.

When he tells his folks the good news – that he’s been able to almost triple his annual spending budget, they aren’t surprised. “John, you’re a Harvard grad. We knew you’d find some people with a decent education to set you straight.” His mom adds, “Now learn to cook - rice!

The morals of this story: Our kids, no matter how privileged, may be making far less than we really think when we translate their salary into food, clothing, shelter and entertainment. Second, there are plenty of safe ways to raise your living standard short of earning more money.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.