Here's a gust post from Marotta Asset Management.
Last week's article explained the wrong-headed decisions behind the current tax-stimulus package, its deleterious effects on an already fragile economy, and how consumers delude themselves in the ways they spend the money. This week I explain the effects of the rebate checks on the savings for retirement. Anyone who spends more than 4% of their rebate will actually lose ground saving toward their retirement.
Retirement is the ability to continue your current standard of living solely through the growth of your investment assets. Raising your standard of living is the fastest way to fall behind your retirement goals. Every time you increase your spending by $1, you need $23 more in your investments when you retire.
So if you spend even half of your $1,800 rebate check and put the other half in savings, you fall $19,800 further behind in your retirement. Spending the extra $900 means you are expecting to continue living a lifestyle $900 greater than the lifestyle you have been living. To support that lifestyle, you will need 23 times that amount, or $20,700 more, in the bank at your retirement. But because you are only putting $900 more in your retirement, you fall $19,800 behind.
The problem worsens with every dollar of rebate you spend. Spend the entire $1,800 and you fall $41,400 behind on your retirement savings. Get tricked by the windfall effect I discussed last week, and you will increase several smaller purchases and spend 2.5 times your rebate check. Spending $4,500 more means you have fallen $103,500 behind in saving for your retirement.
Even back at only spending half of your check, you've spent $900 and only saved enough to do that again next year. You've saved like there's only one tomorrow. To support a constant lifestyle increase and not simply a two-year binge, you can only spend about 4% of the $1,800, or $72.
At this point, I can hear your objections: "But I'd just be spending the $900 this year. I'm not really increasing my lifestyle."
Unfortunately, lifestyle is tricky to calculate. It is easy to ratchet up but nearly impossible to trim down. Just try cutting your spending by $900 this month and adding that amount to your investments if you think it's easy to economize. Whatever your standard of living, there are people living $900 below you who are considering using their rebate check to add the one thing they believe they are missing from your lifestyle.
You can't spend money apart from your lifestyle because that's the definition of lifestyle. If you add an additional $900 to your lifestyle, you will have to cut back by the same amount next year just to get back on track toward your retirement.
Most people spend money they will only receive once and are more cautious about spending additional salary. However, the exact opposite should be true. Money you are given once cannot support an increase in your lifestyle. You have to amortize the money over your entire lifetime and spend only about 4% in any one year. But additional salary can be counted on every year. Therefore you can spend between 70% and 80% of salary increases and still stay on track by always saving between 15% and 30% of your income each year.
A much better idea is to think of the rebate check is as a matching contribution. Imagine the government is making you the following deal: "We will give you a check only if you put it in savings and match it with your own money, cutting your lifestyle this year by that amount."
If you take the government's deal and cut your lifestyle by $1,800 and add that plus the rebate check to your retirement savings, then you really grow rich. First, you have added $3,600 more toward your retirement. But more importantly, by cutting your lifestyle by $1,800, you now need $41,400 less to make retirement a possibility! With one small matching funds incentive by the government, you are a total of $45,000 closer to financial independence.
Staying on course toward retirement is as much about moderating your lifestyle as it is about saving and investing. If you need 23 times your standard of living at age 65, you need about 10 times at age 50, 5 times at age 40, and 1.7 times at age 30. Investments can double quickly, but you must have something saved while you are young to get the process started. Delay saving for several years and you will cut in half your lifestyle in retirement.
Compare what you spend with what you have saved to see if you are on the money toward meeting your retirement goals. And consider that tax rebate gimmick for what it is: another cheap attempt at stopping you from achieving financial independence.
Here's a program I could support as president: Offer to pay people matching funds toward their retirement in accounts they would own and control. We wouldn't even have to call it "privatized Social Security."
A truly brilliant article. We deceive ourselves into imagining that we'll be happy as retirees living on much less than we live on now. If that's true, why don't we begin lowering our lifestyles now to come closer to matching what we expect we'll be living on then? Amazingly, every time I hack into my current lifestyle and save that money, I'm also increasing my retirement standard of living. Maybe the transition won't be as *ahem* abrupt as it might otherwise be, if I keep hacking away.
The government matching program is SO MUCH better than what they're doing.
Posted by: Katy McKenna Raymond | May 31, 2008 at 08:30 AM
FMF, May I link to this article on your site?
Posted by: Katy McKenna Raymond | May 31, 2008 at 08:32 AM
David, I'd have to disagree with you on your premise for the article. Reports are coming in that state a majority of people are using the rebate checks on cost-of-living maintenance; instead of suffering from involuntarily lifestyle retraction due to inflation, they are preventing it from dropping for a month or so. These people expect the money to be gone very soon (if it's not already spent) and worry about the further slide down in living standard. Don't misunderstand; I do see your point and agree in theory with what you are saying. One of the easiest ways to pad your retirement is to cut your overhead, and the easiest action in cutting your overhead is to reduce your standard of living. I also agree that saving your check is the "best" answer to the question of what to do with it. But for a majority of people out there, this isn't going to impact their retirement; it's merely going to stave off household inflationary effects for a little while.
Disclosure: My check is sitting in one of my cash flow accounts waiting to offset the inflation caused by the very government that issued the check, so I might be projecting a bit on this one - even though I am seeing reports stating the same. Not to mention, I am nearly finished writing an article for FMF on inflation and retirement, so I'm a little inflation-and-retirement focused today :).
Posted by: Rod Ferguson | May 31, 2008 at 09:10 AM
Although I generally enjoy the articles from Marotta, I find the premise of this one dubious. Specifically, I don't buy the claim that one must save $23 to make up for every $1 he spends now in order to maintain his lifestyle in retirement.
For example, if you are spending $2,500 a month on a mortgage now, if you pay off your mortgage before retirement then that's $30,000 a year you don't need anymore to maintain the same lifestyle. And there are numerous other areas in which one can expect to save, such as owning one car instead of two.
And how about saving? If you are saving $20,000 a year now, that's $20,000 more that you won't need to maintain the same lifestyle in retirement.
Thus, in short, if I'm living on $100,000 now but will see reduced expenses of $50,000 in retirement then I can live precisely the same lifestyle in retirement on half the income (not accounting for inflation, which cuts both ways, of course).
Posted by: Todd | May 31, 2008 at 09:46 AM
I spent all of my rebate the day I got it, yet I still have all the money! I "purchased" $600.00 worth of mutual funds, which is how much I got.
Posted by: Dave | May 31, 2008 at 11:05 AM
This theory is ridiculous.
Posted by: Lynn | May 31, 2008 at 11:11 AM
Interesting article, though I'm trying to get my head wrapped around what this means for any tax cut. I know for some people this is a hand out, but for most people (and probably the vast majority of people who read this blog and actually received a payment) this is a one year tax cut. I assume this means the Bush tax cuts have ruined my retirement as well since that was 10 years of me having more money to spend through lower taxes and increasing my lifestyle, since taxes are likely to increase again. (Maybe this is the point, that any tax cut that we can't be sure will continue is a bad idea. Therefore any one-time tax break (that by definition does not continue) would always be a bad idea.
Posted by: SS | May 31, 2008 at 11:26 AM
Totally fallacious nonsense!
Posted by: F. Morana | May 31, 2008 at 11:29 AM
Hopefully Congress will continue to ruin our retirements by extending the tax cuts. :)
Posted by: Todd | May 31, 2008 at 02:34 PM
This post gets a little carried away with consumption smoothing orthodoxy.
I think it is possible to blow a one-time windfall without it permanently recalibrating your standard of living. It's like saying one cigarette is enough to make someone a smoker for life.
That's not to say I think the "economic stimulus" checks were a good idea. It's a pretty pointless redistribution of money, a rather crass attempt to placate the masses.
If the idea is to stimulate the economy, lower the corporate tax rate to zero, along with taxes on capital gains and interest. To alleviate energy prices, allow drilling of ANWR and offshore, let oil companies turn the parts of New Orleans below sea level into refineries, and eliminate summer blends and ethanol mandates. Finally, unilaterally eliminate all tariffs and take the farm bill out back and shoot it.
Posted by: Matt | May 31, 2008 at 05:38 PM
I find the theory dubious for many reasons but mainly because it seems to imply that people don't have common sense. It also assumes that everyone is the same.
1. This amount doesn't represent the same thing to everyone. For one family it may be more than their whole savings or at least a significant percentage of their savings. For another family it may be too small an amount to make any difference in lifestyle whatsoever. Most people would fall in between. If the amount is indeed most of one's savings, it may indeed be smarter to save, but not as much for the nebulous "lifestyle" reason as for the fact that in this case one may just not be able to afford to spend it. It would still depend on the type of purchase, person's age, and individual circumstances.
2. Every purchase is different. Spending the rebate on a fancy handbag isn't the same as spending the rebate on your child's braces or anything that you really needed to do for a while and couldn't afford.
3. Assuming one can afford to spend the amount and has common sense, a one time purchase or activity doesn't constitute a permanent "change in lifestyle". If every time you get some "gift" of an item that you wouldn't normally buy you "change your lifestyle", then you shouldn't accept any gifts. One example would be business trips. A lot of people stay in better hotels and eat in better restaurants when on business trips. Doesn't mean next time one goes on a trip as a tourist one would travel in the same style. Sure if someone spends a rebate on a handbag and decides that from now own she'll only buy the same type of handbags this would be a change in lifestyle. Again, people should use their common sense.
4. Our lifestyle isn't a constant. Not only do we splurge one month and may be really stingy the next month, but our whole lifestyle changes based on our circumstances - kids, salary increase, loss of a job. We adapt. Someone earning a 6 digit salary wouldn't continue living the same lifestyle after losing his job, not if one has common sense. So why would a one time purchase affect our whole lifestyle?
5. One should calculate retirement needs based on one's estimated future expenses, the age when one plans to retire, plans for retirement and not on what one spends now. Some expenses (e.g. medical) may be higher, other expenses are likely to be lower. Are you still going to be paying mortgage? Are you still going to be paying for kids in college? Would you need the same clothes if you don't go to the office every day? Would you drive as more or less? What would you like to do after you retire? One should also keep in mind that one's interests change as well as the amount of energy. If you like to go on bike tours around Europe in your 30s, you may not want to do it in your 70s.
For the record: I am not getting any rebate, but if I were getting it it would've been too small an amount to make any difference in my lifestyle. I'd probably save it simply because I can already easily afford to spend as much or more on anything I want. Now, if I were getting 10K and were to spend it on, for example, a more expensive trip than I usually take, it still wouldn't mean the next time I take vacation I would be compelled to spend as much. I have common sense and I'd like to think so do other readers of financial blogs.
Posted by: kitty | May 31, 2008 at 06:35 PM
Bad analysis based on a dubious premise. I expect better from FMF. kitty said it well, but I want to reiterate just in case.
The statement "every time you increase your spending by $1, you need $23 more in your investments when you retire" is misleading. A better statement would be, for every dollar by which you increase your expected yearly spending in retirement, you need $23 more in your investments. But "actual spending this year" and "expected yearly spending in retirement" don't necessarily correlate -- current outlays may or may not be predictors of future costs.
If I spend my whole $1200 or whatever at Starbucks over the course of the year, I may form a $1200/year Starbucks habit, and if I maintain it in retirement I'll need an extra $27,600 in my accounts to be able to handle it. But if I spend my whole $1200 as part of a down payment on my (first) house, I'm not necessarily starting a house-buying habit that I'll need to maintain in retirement; more likely, I'll simply have my mortgage paid off faster and therefore more money to invest later.
In other words, the article is flat-out wrong when it says "spending the extra $900 means you are expecting to continue living a lifestyle $900 greater than the lifestyle you have been living." Spending the extra $900 may or may not mean anything about my expected future lifestyle.
Posted by: LotharBot | June 01, 2008 at 03:10 AM
I agree with Kitty's and LotharBot's responses. I think the theory that $600 windfall will impact your lifestyle for life is really grasping and based on way too much assumption and over generalization.
I think it would have been much more reasonable to simply point out to people how much money they would have at retirement age if they simply invest the stimulus now and then let it grow with compound interest in a tax sheltered retirement account. Thats the point of the article right, encouraging people to save rather than spend? Why not just point out the straight forward benefits of saving rather than cook up some absurd stuff about permanent lifestyle changes.
Jim
Posted by: Jim | June 01, 2008 at 02:30 PM
Katy --
Of course!
Posted by: FMF | June 02, 2008 at 07:37 AM
If the author doesn't like the rebate, then just state the policy reasons why he doesn't like it and leave it at that.
We received 1800, 600 for me, 600 for my wife and 600 for our two kids. This was money we never expected to receive; it was a windfall for us. So to say that by spending it, or any portion of it will affect our future lifestyle is unsupported speculation. If a person takes the rebate and spends it on something that will take annual expenses to maintain, like cable TV, cell phone service or a much more expensive car (with higher insurance, licensing and maintenance costs), then yes, the lifestyle has changed and becomes more expensive. But if a person spends the money on a one-time purchase, like a trip they had not planned to take, or a new bicycle, then there has been no permanent change in lifestyle unless you can prove they will do the same thing year after year, when there is no rebate.
I think the poster's logic is flawed, or at least needs some serious clarification.
Personally, we put 300 in each kid's 529 account. The other 1200 went to our Roth IRAs. Otherwise, our monthly expenses and income remain the same, as does our "lifestyle".
Posted by: rwh | June 02, 2008 at 04:24 PM