Spend 'til the End: The Revolutionary Guide to Raising Your Living Standard, Today and When You Retire

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The Three Commandments of Economics

This book may change your life. If you follow its simple prescriptions -- the surprising rules of true financial planning -- you'll live a more relaxed and happier life. You'll do so by achieving a higher and more stable living standard and a better lifestyle.

These are big claims for a small book. But we aren't offering the revolutionary solution of the moment. This isn't the miracle diet of the week or the sex trick of the month. It isn't even the six mutual funds guaranteed to fix your future. Instead we're providing something with a great pedigree: an economics-based, three-part prescription for personal financial health:

Maximize your spending power.

Smooth your living standard.

Price your love.

Economists have been developing and refining their approach to financial planning for over a century. But few people know about it, and for good reason: it's been impossible to implement this refined approach from a computational perspective. But times change, and today PCs can calculate in seconds what used to take mainframes weeks. With these new power tools, economists can finally move from describing financial problems to prescribing solutions. In particular, they can now help people improve both their financial and personal lives by finding them a higher, smoother, and more rewarding spending path.

"Higher, smoother, more rewarding spending" sounds good. So what's the catch?

There is no catch.

Maximizing your spending power doesn't require working yourself to the bone or even working an extra hour. It means making a host of decisions regardingeducation, career, job, location, housing, mortgage, retirement account, insurance, portfolio, tax, and Social Security, among others, that provide you more money -- potentially a lot more money -- to spend for the same effort.

Take the decision of whether to collect a smaller Social Security retirement benefit starting at age sixty-two or a larger one starting at a later age. Making the right choice doesn't take any more time or effort than making the wrong one, but the consequences for your living standard can be spectacular. The same holds for choosing between jobs, mortgages, retirement accounts, and so on.

Smoothing your living standard means spreading your spending power evenly over time, so you never need worry about running out. It doesn't mean starving now to gorge later or vice versa. Economists call this spreading of your spending power over time consumption smoothing. It is based on the law of diminishing returns -- the well known proposition that you can have too much of a good thing. Six-year-olds have this down. Put them in front of a plate of cupcakes. They'll inhale the first, gulp down the second, struggle through thethird, and then save the rest for tomorrow. In making this spending/saving decision, six-year-olds are smoothing their consumption. They are trying to even out their pleasure from consuming today, when times are good (Dad's been shopping), with their pleasure from consuming tomorrow, when times are bad (Mom's going shopping).

Smoothing your consumption also means protecting your living standard -- making sure it stays relatively steady in good and bad times. For six-year-olds, living-standard protection means hiding the remaining cupcakes from Mom. For us grown-ups, it means inoculating our living standard against adverse changes in income, healthcare costs, taxes, government benefits, and inflation, and making sure that risky investments are truly worth the gamble.

Pricing love doesn't mean selling your firstborn for ready cash. It means knowing what it costs, measured in terms of your living standard, to do things that you'd really love to do. These include taking a wonderful but low-paying job, retiring early, having kids, buying a vacation home, getting divorced, signing up for an Alaska cruise, moving to Arizona, and contributing to charity, among many other things.

Pricing your passions is critical to getting the most out of your spending power. Imagine having to buy the week's groceries at a market that doesn't post prices. You'd surely end up spending too much on things you thought were cheap but were actually expensive, and perhaps too little on things you thought were expensive but were actually cheap. You'd be spending blind and buying too little love for your money.

Maximize your spending power; smooth your living standard; price your love -- these are the Three Commandments of economics. Although the economics lingo may be foreign, the concepts are familiar. We all try to follow these rules most of the time. Just consider the kinds of financial questions we ask:

Does contributing to my 401(k) pay?

Is this mortgage the cheapest?

Should I go back to school?

Should I convert my IRA (Individual Retirement Account) to a Roth IRA?

Am I saving enough to sustain my living standard?

Will my kids suffer financially if I die?

Does holding stock make sense at my age?

Can I afford a cabin cruiser?

Is working until sixty-five worth it?

Can I swing living downtown?

What's a safe rate of retirement spending?

Each of these questions tests compliance with the Three Commandments. Each involves economics' bottom line: your living standard. And each is a version of: Can I raise my living standard? Can I preserve my living standard? Can I sacrifice my living standard?

Posing living-standard questions is easy. Answering them is tough. Take contributing to a regular 401(k) versus a Roth 401(k). The former option means paying less tax now but more later. The latter means the opposite. Which option generates a higher living standard? And how do these choices compare if taxes are increased later on?

Getting the right answer to these seemingly straightforward questions is immensely complicated. But thanks to new economics technology -- technology that calculates your highest sustainable living standard -- such questions can now be answered in seconds.

This book is going to use this new technology to teach you the Three Commandments. It's going to do so in general and specific terms. And it's going to do so in plain English. So even though one of us -- Larry -- is an economist, there won't be any geek talk or equations, just the repeated application of economic commonsense.

Economic common sense, you'll come to see, is at complete odds with conventional financial planning, which, frankly, has as much connection to proper saving, insurance, and investment decisions as French fries with melted cheese have to a healthy diet. Indeed, this book will argue that virtually every bit of conventional financial wisdom you've heard over the years is simply wrong.

So get ready. This book is going to turn your financial thinking upside down. Here's a sample of some of the financial mind-benders you'll shortly encounter -- and understand:

Setting retirement spending targets is asking for big trouble.

The poor and middle class should hold relatively more stock than the rich.

Diversifying your portfolio is generally a bad idea.

Stock holdings should rise, fall, rise, and fall again with age.

Having children may lower your need for life insurance.

Spouses/partners with the highest earnings may need the least life insurance.

The rich have bigger saving and insurance problems than average people.

Maximizing retirement account contributions is generally undesirable.

Waiting to take Social Security can dramatically raise your living standard.

Oversaving and overinsuring are risky.

Mortgages offer no tax advantages for most households.

How Come?

This book is full of practical steps to improve your financial life. Most of these steps, ironically, have nothing to do with investing in stocks or bonds. Indeed, we don't get to portfolios until part 5. But this book is far more than just a "how-to" financial formulary. It also implants a wee bit of economic theory in your cranium to help you understand economics-based financial planning. Also, expect to get a sense of the computational challenges inherent in proper planning. Once you do, you will realize the primitive nature of conventional planning tools and why it's taken economists so long to develop useful software.

Finally, get ready for a sobering survey, spiced with gallows humor, of financial pathology American style -- a survey that will leave no doubt: Homo Americanus is not Homo economicus. Americans have personalities, feelings, desires, cravings, appetites, crazes, addictions -- you name it -- none of which enters standard economic theory. To the contrary, standard economic theory presumes that we are super-rational automatons who never crack a smile, never grab a kiss, never get angry, never suffer a lapse in financial judgment, and never get an urgent need to shop till we drop. But, as we'll discuss, neuroeconomics -- the new economics subfield that uses brain waves to study economic choices -- shows that our emotions are fully engaged when we make financial decisions.

This is not to denigrate the ability of standard economic theory to predict general financial behavior. A great deal of such behavior lines up well with theoretical predictions. For example, the theory predicts that people will save for retirement -- and most people do. But when it comes down to comparing what any given household should do with what that household is actually doing, the gulf is huge. For example, household A should be saving 5 percent of its income, not 20 percent. Household B needs life insurance and is holding $500K, but really needs $1.5 million. Household A should diversify its financial assets and is holding 30 percent stock and 70 percent bonds, but the portfolio shares should be reversed. In other words, most of us try to do the right thing, but we often miss the target -- badly.

The huge gulf between actual and prescribed behavior tells us we need help in determining and implementing precise economics-based, household-specific recommendations.

Our survey of Americans' financial ills will reassure you that whatever financial problems you face, they could be worse. It should also convince you that whatever else one might say about conventional financial planning, it has failed miserably in securing the financial health of tens of millions of Americans. In short, it's time for a financial-planning approach that actually works and that is guided by an overall framework -- economic theory -- that makes sense.

The Game Plan

Our book has five parts. Part 1, "Smooth Financial Paths," takes you on a trip -- actually, a drug trip -- to illustrate in the simplest possible setting what we mean by living standard, consumption, and consumption smoothing. We're going to start you out as a drug dealer (to avoid tax and Social Security complications) and then gradually transform you into a more familiar Middle American. During each of your metamorphoses, you will not only be smoothing your consumption, but also maximizing your spending power, pricing your love, or both. By the end of your trip, you'll have a clear sense of financial health and be poised to learn why conventional financial planning promotes the opposite: financial pathology.

Conventional planning, as you may already know, asks people to set their own retirement spending target. Then it asks you to predict what your survivors should spend. What you probably don't know is that setting one's targets correctly is virtually impossible. Worse, even small targeting mistakes can generate major upheavals in your standard of living as you proceed through life.

The planning/investment/insurance industry knows that making you set your own targets is asking you to do all the hard work. So the industry provides quick targeting advice. This "advice" invariably involves wildly high saving and insurance recommendations. No surprise -- the industry is trying to sell you a product. It is not trying to help you smooth your consumption.

Once the industry cons you into accepting impossibly high saving and insurance goals, it "helps" you achieve them by terribly misusing what's called Monte Carlo analysis to con you into buying high-cost and high-risk investments. Follow this advice, and you'll face far too much variability in your living standard.

The financial industry's practice of soliciting risk is no minor matter. It can gravely damage your financial health and constitutes serious financial malpractice. The industry, by the way, ranges from your neighborhood financial planner to major financial companies, including "good guy" companies, such as TIAA-CREF, Fidelity Investments, and Vanguard -- three of the nation's largest vendors of mutual funds and insurance. All are systematically violating the Hippocratic oath: "First, do no harm." Indeed, conventional financial planning is virtually guaranteed to make us financially sick. Some firms do far more harm than others, but all of them call what they do financial planning.

Whether conventional planning or our own decision making is the cause, we are all financially sick. This "we" includes you.

We don't care if you're Suze Ormond (the best-selling financial author), Jane Bryant Quinn (Newsweek's acclaimed financial columnist), or any other self-proclaimed financial healer with millions of acolytes. We don't care if you're Peter Lynch (Fidelity's all-time top money manager), David Swensen (Yale's brilliant endowment investor), or any other renowned investment guru: you are financially sick.

How do we know this?

Because nobody -- not Suze, not Jane, not Peter, not David, not us, and not you -- can maximize her spending, smooth her consumption, or price her love on her own. It's too damn tough, just as it's too damn tough to think thirty moves ahead in chess. Deep Blue -- IBM's supercomputer -- can think that far ahead. But no human on earth, not even Garry Kasparov, can come close.

Skeptics should consider this brief list of interrelated factors in determining one's financial future: household demographics; labor earnings; retirement dates; federal, state, and local taxes; Social Security retirement, survivor, and dependent benefits; private pension benefits; annuities; regular and retirement account assets; retirement account contributions and withdrawals; home ownership and mortgage payments; borrowing constraints; economies in shared living; dates for taking Social Security; Medicare Part B premiums; the relative costs of children; planned changes in housing; the choice of a state in which to live; the financing of college and weddings; the role of inflation in lowering the real cost of mortgage payments; the real value of one's pension (if it's not fully inflation-indexed); paying for one's dream boat; and so on.

Now multiply all that by another factor: each of these variables demands consideration in each and every survival state -- situations in which the household head or spouse/partner has died. And up until now, at least, only a small number of people have used the right software to get anywhere near consumption smoothing.

Our financial pathology doesn't begin and end, however, with the wrong financial objectives and the wrong planning tools, although these deficiencies can easily put us in the economic ER. As psychologists have been telling us for years, most of us are, to put it politely, just plain nuts. We're compulsive, irrational, depressed, stressed, manic, addicted, bipolar, panicked, and anxious. Any one of these maladies can lead us to create a first-rate financial mess.

This point -- that the world is populated by economic neurotics and psychotics rather than fabled rational economic man -- has only recently dawned on economists. (The profession is only 330 years old.) Indeed, in recent years economists have created a whole new field -- behavioral finance -- to study the financial decisions of crazy people -- namely, us and you.

Part 2, "Financial Pathology," provides the aforementioned quick tour of financial illness and its causes. It then pushes on to discuss financial malpractice and its practitioners, and quantifies just how bad conventional advice can be.

We hope this book advances the standard of care that financial planners and the companies we mentioned above provide their clients. But the fact is that you don't need these companies or financial planners to give you advice. If you own a personal computer, you can raise your living standard, smooth your consumption, and price your passions far better than any financial planner or company you might hire.* And if you don't own a PC, you can get much closer to true financial health by basing your financial decisions on the examples presented here and at www.esplanner.com, and www.assetbuilder.com.

* The professional standard of care will change when financial-planning clients insist on plans that make economic sense and when major financial institutions perceive that their Web "tools" and other financial elixirs are an embarrassment, if not a legal liability.

Part 3, "Raising Your Living Standard," tells you, among other things, how to decide, from a financial perspective:

whether education pays

which career to pursue

which job delivers the highest spending power

where to live

how to finance your home

how much to contribute to retirement accounts

whether to save in regular or Roth retirement accounts

the best age to begin collecting Social Security

whether to annuitize your retirement assests

whether to take out a reverse mortgage

whether to pay down your mortgage

whether to hold stocks or bonds in your retirement account

whether to use a broker

Part 4, "Pricing Your Passions," helps you make a variety of lifestyle decisions that can make you much happier even if they reduce your living standard. These decisions include:

getting married

getting divorced

retiring early

having kids

assisting your kids financially

contributing to charity

Part 5, "Preserving Your Living Standard," is about risk taking and risk avoidance. Consumption smoothing is biased toward risk avoidance. This goes back to the law of diminishing returns. If you're famished and sitting in front of three cupcakes, you'd surely turn down a 50-50 chance of either losing one or winning an extra.

Why? Well, if you lose the gamble, you'll get to eat only two cupcakes and really wish you had a third. If you win, you'll already have eaten three when you reach for the fourth. With three in your gut, you'll probably say, "Gee, I'm getting a bit stuffed." So the fourth cupcake -- the upside -- has much less value than the third cupcake -- the downside.

This is why taking fair gambles is an economics no-no. But if the gamble is sufficiently favorable -- if you have, say, a 50 percent chance of losing one cupcake and a 50 percent chance of winning ten cupcakes, flipping the coin may be worth it. So economics doesn't counsel absolute prudence. Gambling is OK, but only when the odds are favorable enough to overcome your risk aversion -- your desire to avoid loss.

Investing in stocks is an example of a favorable bet. Historically, stocks have provided a much higher return than bonds. But investing in stocks can entail lots of living-standard risk. Part 5 lets you see this risk with your own eyes via a living-standard risk-reward diagram. For those used to thinking about portfolio choice based on the risk-return (mean-variance) efficiency frontier diagram, now five decades old, this new diagram will be an eye-opener. It shows how the level and variability of our living standards change as we age, based on how we invest our assets and how we spend them.

We'll use the living-standard-risk diagram to consider whether stocks are safer the longer you hold them (they aren't), whether lifecycle funds properly adjust your portfolio holdings as you age (they don't), and whether you should follow a popularly recommended 4 percent asset-spend-down rule in retirement (you shouldn't).

Part 5 also examines the other major risks to your economic life: the risks of losing your earnings, dying too soon, living too long, experiencing inflation, tax hikes and Social Security benefit cuts, and long-term care. Although it might seem impossible to limit many of these risks, there are, as we'll explain, novel ways to inoculate yourself against (hedge) each of them.

Deciding which risks to take and which to avoid is particularly tough for two reasons. First, we face a goodly number of different risks. Second, how we evaluate any given risk depends on how we're handling the others. Thus, holding lots of stock in our portfolio is one thing if we're in a highly secure job. It's another thing if we're in a job that could disappear overnight.

Part 5's parting advice is to take a safety-first approach to risk taking. The idea is to start from a position of maximum risk insulation and consider from this vantage point if any risky opportunities make sense, be they investing in the stock market, canceling expensive insurance policies, switching to riskier employment, or taking off the inflation and policy hedges we'll tell you about. If none does -- if a maximally safe and secure financial future floats your boat -- stick with it. There's no shame in playing it safe.

Full Disclosure

Much of the book contains examples based on ESPlanner™, the only publicly available personal financial-planning software program developed by economists. ESPlanner, which stands for Economic Security Planner™, is marketed to individuals, financial planners, educators, and employers at www.esplanner.com by Economic Security Planning Inc.*

Larry is president of the company and has a financial stake in the software we'll be using to illustrate the Three Commandments. Scott does not. He likens ESPlanner to VisiCalc, the first spreadsheet program created in the late 1970s. VisiCalc launched the personal computer industry and played a major role in driving sales of the Apple II. But over time it was supplanted by Lotus 1-2-3, which was supplanted by Excel. ESPlanner, while the first commercial consumption smoother, will surely not be the last and may not even retain top market share in the long run. As with VisiCalc, the importance of ESPlanner is what it portends.

So please don't view this book as a sales pitch for ESPlanner. You can read and benefit from this book even if you never buy ESPlanning. Regard this book instead as a sales pitch for an economics-based approach to financial health. You should also know that economic science has only one prescription when it comes to financial planning -- namely, consumption smoothing -- and all consumptionsmoothing computer programs (there are hundreds, if not thousands being used in research) that carefully calculate taxes and Social Security benefits will generate the same recommendation as ESPlanner for the same inputs.

This book's examples and those posted (under Case Studies) at www.esplanner.com and www.assetbuilder.com will give you a pretty clear sense of how much to save, how much to insure, and how much to invest in risky securities. You'll also learn about a wide range of moves that can raise your living standard. Finally, you'll start to see the true living-standard price of a host of lifestyle decisions.

That said, since ESPlanner will be used to produce our examples, it's important to point out that the program has been well vetted. It's been on the market for several years and has been sold to thousands of households. The program has been featured in leading newspapers, magazines, and Web sites, including the New York Times, the Wall Street Journal, the Washington Post, the Boston Globe, USA Today, Consumer Reports, the Dallas Morning News, the Baltimore Sun, Time, BusinessWeek, Forbes, Fortune, Money, MSN Money, SmartMoney, Kiplinger's Personal Finance, Investor's Business Daily, Fox News, NBC News, MarketWatch, CFO Magazine, CNNMoney, Bloomberg.com, Motley Fool, Yahoo-Finance, InvestmentNews, Financial Advisor, and The Journal of Financial Planning. ESPlanner has also been strongly endorsed by top economists, including the late Franco Modigliani, who won the 1985 Nobel Prize in Economic Sciences for work on the life-cycle model of saving.

ESPlanner's patented algorithm actually features two dynamic programs -- one to smooth the household's living standard and one to determine the life insurance holdings needed to protect that living standard -- that iterate with (talk to) each other. In less than five seconds the program generates either a perfectly smooth living standard path or the smoothest living standard path consistent with not going into debt (apart from borrowing for a home). In these five seconds, the program not only does iterative dynamic programming but also calculates taxes and Social Security benefits in thousands of survivor states.*

How do we know that the answers ESPlanner yields are accurate? We can verify from the financial plan's balance sheets and other reports that (a) the recommended living standard path is either perfectly smooth or as smooth as it can be absent borrowing; (b) the financial plan considers all household assets, earnings, special expenditures, housing expenses, college, estate plans, taxes, and Social Security retirement benefits; and (c) survivors receive precisely enough life insurance to maintain their former living standard.

Now it's our turn to ask a question: How does the conventional method of financial planning stack up against the economics approach? Read on and find out.

Copyright © 2008 by Scott Burns and Laurence J. Kotlikoff