When Behavioral Economists Advocate Misbehavior

by: Laurence Kotlikoff

This article, joint with Rick Miller, President of Sensible Financial Planning, criticizes a recent WSJ article by two behavior economists.

Dan Ariely and Aline Holzwarth suggest that people need to spend a whopping 130 percent of pre-retirement earnings in retirement.

Why so high? Because they asked people what they wanted to spend, not what they could afford to spend.

Household economics has two maxims - smooth your consumption (living standard) through time and do lifetime budgeting.

Ariely and Holzwarth are recommending starving when young to party when old. That's bad behavior.

A recent Wall Street Journal article by Dan Ariely and Aline Holzwarth suggests that most people dramatically underestimate how much money they will need in retirement. Unfortunately, their headline conclusion is invalid, even though they rely on an important principle of behavioral economics.

The authors emphasize that detailed planning for spending in retirement is hard (we agree). People tend to underestimate how long they will live, and they are uncertain at best about what they will do in retirement and how much it will cost. Behavioral economics teaches us that we tend to do a poor job of imagining our future, especially if it's distant. We aren't very good at thinking about how long we will live, either.

Forecasting spending is easier than it looks

People struggle to produce detailed spending plans for this year, let alone for 10, 20, or more years into the future (people are living longer, and many of today's retirees will live into their late 80s and even their 90s). However, most people have a living standard they are used to and comfortable with. They would like to continue to enjoy it after they retire. But they are likely to be uncertain how much that living standard costs.

The article correctly indicates that most (but not all) financial advisers ask their clients how much they will want to spend in retirement. These advisers have no alternative - their planning software requires desired retirement spending as an input. Clients will almost certainly guess wrong, and their advisers will tell them to save too much (if the guess is high) or too little (if it's low).

A more sophisticated planning software tool, developed by one of us (Kotlikoff) and used by one of us (Miller) in his financial advisory, is available that allows advisers to advise their clients on how much they can afford to spend every year, and how much they should save to maintain their spending after retirement. There is no need to guess. There's also a version that households can buy to plan on their own.

A wish list is not a plan

The authors recommend a process for estimating roughly how much you'd like to spend and then multiplying by the number of years you expect to be in retirement. However, writing down a wish list is different than developing a plan. No tradeoffs or choices are required because budget constraints (time or financial) are not considered.

It's one thing to say that people wish they could spend 130% of their salaries in retirement. It's another thing entirely to say that people should decide to spend much less and save much more than they currently do while working so that they can spend much more in retirement.

A back of the envelope calculation suggests that even absent the unfortunate impact of taxes, spending 130% of salary from 65 to 85 requires saving 48% of salary from 25 to 64. We suspect that most people would find saving enough while working to spend at wish-list levels in retirement to be unacceptably painful. In short, Ariely and Holzwarth are proposing crazy over saving to mitigate crazy undersaving.

And about those Saturdays

Consistent with the authors' assertion, there is evidence, by University of Chicago economist, Erik Hurst, that spending on activities that require time increase slightly in retirement, while spending on items where time can be substituted go down. On balance, total spending in retirement declines slightly. In short, there is a Saturday effect, but it's small, and it's offset by a "retirement effect" - less spending on work-related items (clothing, transportation), and less spending on food, as retirees devote more time to cooking, and less of their resources to purchasing food preparation from others.

Summing up

It is true that there is value in thinking about your retired life, and especially about how you will spend your time. Many retirees find that they don't have enough to do once they retire, and some struggle to find meaning.

Saving for retirement is important, and you should do it. However, you don't have to save nearly as much as Ariely and Holzwarth seem to suggest. You can enjoy retirement without beggaring the life that comes before. It's essential to balance your retirement dreams with your working-life realities.

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.