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57 of 60 people found the following review helpful:
3.0 out of 5 stars
Interesting but too erratic read why., July 14, 2008
Kotlikoff is a very interesting writer/economist. His previous book The Coming Generational Storm: What You Need to Know about America's Economic Future is a must read for anyone interested in the actuarial position of Social Security. Now, Kotlikoff and Burns focus on financial planning. To investigate it, Kotlikoff developed a sophisticated program (ESPlanner). Its underlying methodology is "consumption smoothing" that consists in evening out your discretionary income over your lifetime.
Per the authors, the financial service industry ignores consumption smoothing methodology for several reasons. First, it is really complicated. It includes many variables (mortgages, change in member of households, AMT, Social Security benefits taxation, etc...). Second, it reduces retirement savings needs. Third, it reduces the investment risk you need to incur to reach your goals. Thus, consumption smoothing would cut into the sales of financial products.
The authors spare no one in the financial service industry. The mutual fund managers don't earn their fees as 70% of them routinely fall behind the stock indexes. And, the 30% that beat the market change every year. Thus, the 30% who beat the market are just Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. Hedge funds don't have a chance to make up for their high fee structure (1% management fee; 20% of returns). Insurance salesmen care more about their commission than your finances.
The authors are at their best when dealing with the intricacies of Social Security and Medicare. They explain unique strategies to maximize consumption smoothing such as Social Security double dipping. Similarly, you can come ahead by giving to a Charitable Gift Fund because it markedly reduces your taxes on Social Security benefits. They stress how rapidly Medicare premiums are rising and how we should boost savings even during retirement to withstand that fiscal shock.
Many of their other recommendations make good sense. Those include holding stocks in taxable accounts and bonds in tax advantaged ones (IRA, 401k) to lower your tax burden. They recommend using index funds instead of regular mutual funds to save on costs and boost returns. Diversify your 401k holdings away from your employer's common stock to reduce your own portfolio risk. They also suggest that marriage is a good deal from a tax standpoint in most cases. Their chapter on how to hedge against potential increase in taxes and inflation and upcoming cuts in Social Security benefits is very good. Their chapter on long term care is excellent.
But, some of their investment advice is less sound. Kotlikoff recommends inflation indexed Treasuries (TIPs) as a safe investment that is guaranteed to keep up with inflation (just as Robert Shiller did in Irrational Exuberance). But, on an after tax basis TIPs are unattractive. The yield they offer above inflation is really low (< 1.5% for 10 year TIPs). When inflation is higher than 3% you incur negative real returns after tax. This is because the entire return (inflation + yield) is fully taxable by the IRS. Also, TIPs with longer maturities offer little extra yield that does not compensate for the increase in interest rate risk. Thus, with TIPs it is questionable you can preserve capital let alone grow it. As a better alternative, I suggest medium term Munis.
Occasionally, they make errors. Upon retiring, Kotlikoff recommends converting your 401k into a Roth IRA because you may hit the 28% AMT that is lower than the 35% maximum tax rate. But, you don't "benefit" from the AMT because your tax liability is always the higher of the AMT or your regular taxes. Also, Kotlikoff suggests people's living standards go up when home prices fall because they save on insurance premium and property taxes. But, they don't. Insurance premiums are based on the replacement costs of the house. And, property taxes are based on assessed value. Replacement costs are always lower than the home market value. Assessed value almost always is lower too. Thus,in the majority of cases declining home prices will not save you money.
The authors make other questionable statements. Supposedly, on a consumption smoothing basis, a plumber maintains a higher living standard than a doctor. I don't believe that. Also a college education supposedly provides little financial benefits vs just high school. Meanwhile, figures from the US Census indicate that college grads make nearly twice as much as high school grads. I ran the numbers and calculated the NPV of a college education was several hundred thousand dollars. Also, they suggest that having a second child cost either little or is a cost saver. That's pretty hard to believe too.
Occasionally, the authors appear to contradict themselves. Late in the book, the authors share that per the Employee Benefit Research Institute 56% of retirees spend either the same or more than their pre-retirement level. This contradicts the authors' position that the financial service industry advocated replacement rate of 70% of pre-retirement earnings is too high. The mentioned survey instead suggests it may be too low.
In another chapter, the authors oversell the concept of annuitizing assets and reverse mortgages. That's where they push consumption smoothing too far. By annuitizing your assets and getting a reverse mortgage, you wipe out your estate leaving nothing for the next generation.
This financial planning book is a bit too erratic. To build a robust foundation, I recommend instead The Random Walk Guide To Investing.
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31 of 34 people found the following review helpful:
4.0 out of 5 stars
Income Smoothing 101, August 9, 2008
A little background on myself before I start the review: I have read over 200 books on investing, so I count myself lucky if I learn 1 new thing for each new book I read. I have read quite a few columns by Scott Burns and generally agree with him on his ideas. I have read several papers and articles by Kotlikoff. I have not read any prior books written by either of these gentlemen. I have been a fan of index fund investing since 1990.
Before I read this book, I was also aware that Kotlikoff sells his own software package ESPlanner for $150 a copy plus $50 annual update fee ($200 for Monte Carlo version plus $50 annual update fee).
My first comment is that my perception is that Kotlikoff wrote the majority of this book. I base this upon the early writings of Kotlikoff and Burns that I have read.
I have long known that index funds usually beat roughly 70% of the actively managed funds in any given year......and my gut intuition is that similar statistics apply to the latest rage.....hedge funds. Kotlikoff points this out in a slightly different way saying that if 70% of mutual funds with the managers paid 1% of assets per year and 0% of the profits can't beat their appropriate index.......then there is no way a hedge fund charging 2% of assets per year and taking 20% of the profits will ever beat out index funds.
Kotlikoff also expresses the lack of financial literacy of Americans in a new way. I already knew that almost all Americans received no education in investing in our high school and college system. I used to get a kick out of the periodic investment tests that Money magazine used to give to average Americans..........and they consistently received grades of F on the test.
Kotlikoff asks how well Americans really know the subjects they are taught in our educational system, like geography. He points to surveys where these percentages of 18-24 year olds can not find these countries on a world map:
11%..............US
29%..............Pacific Ocean
58%..............Japan
69%..............England
85%..............Iraq
Kotlikoff says that if Americans don't really learn geography in an educational system designed to teach them geography.......then how will they ever learn basic investing skills.
Kotlikoff does devote quite a bit of time to behavioral finance.
Kotlikoff blasts the financial planning traditional rule-of-thumb that people should assume they will need about 80% of the income in retirement that they had their last working years. He argues that using the 80% rule causes too many people to save too much and some people to save too little. He criticizes the source of the 80% rule, the AON-Georgia State studies because they take survey income just prior to retirement, and then adjust it to retirement spending. He argues this methodology is not accurate enough and the financial products industry wants an 80% rule-of-thumb because they make more money based upon higher savings and investments.
Some pundits of Kotlikoff's idea the 80% rule-of-thumb is really the rule-of-dumb....argue that the 80% rule-of-thumb may be too low because future retiree health care costs are rising so much faster than inflation.
I have long advocated that some group should survey Americans just prior to and then during their retirement years. All of the financial data must be corroborated using financial statements since most Americans have no idea of their specific spending or investing lives. Such a study would be expensive........and maybe that is why it has never been done (to my knowledge).
I was a little surprised at Kotlikoff's statistic that 33% of homeowners get no federal tax break on their property tax and mortgage interest.......because these do not exceed the standard deduction limits.
Kotlikoff argues that everyone should pay off their mortgage. I completely disagree with this recommendation. For his financial analysis, Kotlikoff only uses bonds as the investment you would make if you did not pay off your mortgage. My calculations, and calculations done by many others......show that one is likely to earn 2 to 3% after-tax on the spread between the cost of the money (mortgage cost after tax) and the return of the money (60:40 portfolio in low cost index funds)after-tax. Once you get close to retirement, many people pay off their mortgage to give them peace of mind in retirement.........I have no argument with this if it gives you peace of mind.......but financially it is not the best decision.
Kotlikoff also presents the little known option of starting to withdraw Social Security, then later stopping the withdrawals........paying the government back......and then collecting higher payments for the rest of your life. From a behavioral finance point of view, I doubt many people would ever take this option. I also know of one case where this was done recently...........and it took an incredible amount of paperwork hassles to get it completed.
Kotlikoff also suggests using an income smoothing approach to get fairer divorce settlements. A few years ago I had personal experience helping a family member through a much contested divorce process. I was surprised to learn that the law does not require the use of net present value to fairly divide defined benefit pension plans. The law in Illinois only requires that the two parties reach an agreement which both parties think is equitable.......and the judge had to agree it is equitable. The customary practice in the courts of Central Illinois is to value pensions based upon the current cash out value of the pension........and not on the present value of the pension. In theory, I have no problem applying Kotlikoff's income smoothing approach to divorce........but in reality.....it will probably not be accepted in a contentious divorce battle.
Before reading this book, I was aware of using a charitable gift fund (e.g. from Vanguard) as an estate planning tool. I was not specifically aware that in many cases it gives the donor a higher lifetime net income after tax. I will be checking this concept out a little further through other sources.
I disagree with Kotlikoff's assertion that conventional financial planning recommends that your asset allocation to stocks versus bonds should change dramatically over time (e.g. using the Rule of 100). Bengen's work, the Trinity Study, and many others have shown retirees should hold at least 50% stocks in their portfolio to protect against inflation. Of course, if your portfolio is more than large enough to support your retirement living expenses, then you don't have a need to take as much risk and you could drop below the 50% stock allocation.
Kotlikoff argues that people's asset allocation should be adjusted about 4 times throughout their lives based upon changes in human capital and Social Security payments.
Another widely accepted rule-of-thumb that Kotlikoff blasts is the 4% safe withdrawal rate rule. It says that one should not withdraw more than 4% of your portfolio (with an annual inflation adjustment) to prevent outliving your money. The 4% rule is also based upon a 30 year retirement period and having at least 50% stocks in your portfolio (Bengen and Trinity Study).
Kotlikoff blasts the 4% SWR rule because it ignores pensions and Social Security. I completely disagree with this assertion. What idiot would ignore the retirement income from pensions and Social Security? Here is a typical application of the 4% SWR for a 64 year old couple who plan on retiring next year:
Current income........$100,000
Income Needed at Retirement......80% of $100K = $80K (this is 80% replacement rate rule)
Income from pension.......$40K
Income from SS............$28K
Income Shortfall.....$80K - $40K pension - $28K SS = $12K
The 4% SWR says you need a portfolio equal to 25X the amount of income you need to generate. So this couple needs a portfolio of 25 x $12K = $300K.
Kotlikoff also points out the well known phenomena that just because the historic return of stocks has been 10% per year.....you can not withdraw 10% of your portfolio each year. The reason is the sequence of returns may cause you to outlive your money. If the stock market has a Bear market during the first few years of your retirement, then your portfolio does not have time to recover to acceptable levels. William Bengen pointed this out back in 1994.
So if Kotlikoff's income smoothing approach is the best thing since sliced bread, then why has virtually none of the traditional financial planning industry accepted it? Why don't the Vanguard or Fidelity web sites offer an ESPlanner equivalent calculator? Kotlikoff would argue it is not accepted because if it was.......people would not save and invest as much........and the financial industry would lose profits.
I think there are several reasons his income smoothing approach has not been better accepted. One reason is there are already alterative financial planning software packages used by planners which give the same information (see May 2005 issue of Financial Advisor magazine story IS ESPLANNER+ BETTER? By Joel P. Bruckenstein)
Kotlikoff assets that traditional financial planning methodologies result in many people saving too much money and some people saving too little. With our US national savings rate now at 0%, do we really want to tell people they don't have to save as much for retirement? I also assume (I have never used ESPlanner) that ESPlanner requires some time by the user to enter more data than traditional web site planning calculators. With the US citizen's short attention span (witness 8 second sound bites on TV)......how many people will take more time to enter data into ESPlanner versus a quick Vanguard or Fidelity calculator?
Kotlikoff does correctly argue there are too many variables involved in retirement planning for the average person to consider. I would argue that Kotlikoff's ESPlanner might give a false sense of security to its users.......because there is no way to know future asset class returns, correlations between asset classes, inflation, tax policies, life spans, etc. It may be a better trade-off for people to quickly use a conventional web site calculator with a Monte Carlo analysis and get a general idea of their condition versus spending a lot of time on ESPlanner. I would also agree with Kotlikoff that the 80% replacement ratio is too general a rule-of-thumb.....it is probably close enough for people just starting their working careers.......but once you get within 5 years of retirement.....you should determine your real spending needs in retirement. You can use TurboTax to project exactly how much income you will need to have in retirement.....considering your pension, Social Security, and investment income.
Over-all, this book was readable. Time will tell if Kotlikoff's income smoothing approach will gain traction as a new tool in the financial planning toolbox.
Other good books on investing are shown below:
Index Mutual Funds: How to Simplify Your Financial Life and Beat the Pro's
The Richest Man in Babylon
Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
The Millionaire Next Door
The Four Pillars of Investing: Lessons for Building a Winning Portfolio
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition
The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life
The Bogleheads' Guide to Investing
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24 of 27 people found the following review helpful:
3.0 out of 5 stars
Important, stimulating, regrettably flawed, August 15, 2008
The greatest value of this book is that it got me to "think outside the box" that has been built for me by decades of financial writers, employer 401(k) seminars, and retirement guides. It is a popular introduction to a new way of thinking about financial planning called "consumption smoothing," advocated in particular by BU professor Laurence Kotlikoff. I think almost everyone should read it. We are all sick from an overdose of the conventional wisdom and this book is therapeutic.
But I'm going to devote the rest of this review to knocking it.
It is a popular introduction. Too popular. The breeziness of the writing style goes beyond the Strunk and White's worst nightmare. Schticks like naming hypothetical characters "Bill and Hillary" or "Donald and Ivana" or "Dr. Ruth" annoy and distract me like the scraping of a fingernail on a blackboard. The book is replete with dialog like "I'm going to convert!" "You found Jesus?" "Not quite. I'm going to convert all my 403(b) money to a Roth IRA to save taxes." Ewwwwww!
What I take from this book is that our financial lives contain such unexpectedly complicated interactions that few decisions can be intuited or considered in isolation. For example, the financial aspects of a mortgage: the interest is deductible, but only if you itemize... and interest decreases with time while the standard deduction, being inflation-indexed, increases with time. So for many families, the tax savings on interest deductibility last for only a few years. But there are other complexities as well; by the time I finished the chapter on the tax and consumption-leveling implications of a mortgage, my head was spinning. I was glad that I paid off my mortgage long ago and don't need to think this stuff through.
Unfortunately, there is a hidden subtext: you need computer software to make sensible decisions. Kotlikoff and Burns are, of course, associated with such a piece of software, ESPlanner, which they disclose in their introduction. The book seems to go out of its way _not_ to sound like an ad for ESPlanner. But the result is a lack of any guidance at all. Most financial books will give some rules of thumb, some worksheets, some links to free online financial calculators. This book gives you reasons for distrusting such aids. Its hypothetical characters are forever going "to the computer" or "making an analysis" to evaluate some course of action and excitedly reporting their discoveries: "do you realize that we gain only $3,607 a year of lifetime spending for each additional year of work?" It doesn't say how he "makes that analysis." We must assume it is ESPlanner. It does not tell how I (who happen to own a Mac and thus could not run ESPlanner even if I wanted to) could "make that analysis."
Now, the book has a metaproblem of its own. I've long suspected that tools such as Fidelity's Retirement Income Planner or Financial Engines, suffer from grotesque overprecision. Even the uncertainties of the stock market pale by comparison with the uncertainties in one's personal life. It's fun to extrapolate the consequences of a difference between a mutual fund with an 0.2% and an 0.5% expense ratio, compound them out for twenty years, and see how many dollars that is, but I've never been sure it's meaningful.
The book's central tenet is that we should focus on consumption (how many dollars per month we have to spend throughout various stages of our life) and on "consumption smoothing" (equalizing standard of living throughout our various life stages), as opposed to mindlessly piling up the biggest heap we can by age 65, or calculating what age for claiming Social Security will pay us the largest number of total dollars. I agree with that.
But it then contains an assumption, not very carefully presented, that our happiness depends on smoothing that consumption; that it is a terrible thing if our standard of living varies by 25% from one part of our life to another. I'm not at all sure I buy that.
And then it contains the worst assumption of all: that by using a tool (like ESPlanner), we can succeed, in some meaningful way, in planning our financial life course--quantitatively--over a period of fifty years or more.
Of course, this is the same assumption the retirement workbooks of the world make: "Choose column A if you think stock market annual returns for the next thirty years will average 6%, B for 8%, C for 10%..."
After reading the book, I am torn between two courses of action:
a) run right out out and buy ESPlanner and a computer to run it on and trying to dig out twenty years of records...
b) luxuriate for a few days in analysis paralysis and a sense of utter inadequacy at the ignorant way I've led my financial life for forty years... then snap out of it, shrug and say Eh! I'll put 30% in a stock index fund, 70% in a bond fund, have my wife claim Social Security at 62 and try to delay mine as long as possible because some article I read said that's what fashionable couples are doing these days, and hope for the best, and go take a walk in the sunlight.
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