Laura Rowley Money & Happiness

Larry Kotlikoff hates conventional wisdom.

In his new book, "Spend 'til the End: The Revolutionary Guide to Raising Your Living Standard --Today and When You Retire," the Boston University economist declares war on the financial services industry and its traditional advice.

Striking a Balance

It's an appropriate read for the Fourth of July weekend, because it demands a revolution in thinking about monetary decisions -- from where to live to how much to save for retirement to whether you should pay off your mortgage early.

"This was supposed to be a complete demolishing of conventional personal finance, because the standard advice is so at odds what economic science says," Kotlikoff says.

"Spend 'til the End," co-authored with syndicated columnist Scott Burns, advocates consumption smoothing -- adjusting your spending, saving, insurance, and asset holdings on an ongoing basis to maintain a stable living standard. The idea is to strike a balance between living it up now and starving in retirement, and sacrificing fun now to scrimp for the future, ending up with a mountain of cash you're too old to enjoy.

Addressing Personal Finance Malpractice

The book suggests that the choices you make about education, career, job, housing, retirement accounts, and insurance, among other areas, provide more money for the same effort.

"People are making mistakes on both sides -- 40 percent are under-saving and 30 percent are over-saving," says Kotlikoff, who has developed dynamic programming software called ESPlanner that makes consumption recommendations based on dozens of criteria. (I've tried it; I'm an over-saver.)

"I'm not making a living selling software," Kotlikoff insists. "I got into this because I got pissed off at seeing industry malpractice left and right."

How Much Do You Need to Retire?

In particular, Kotlikoff condemns income-replacement formulas suggesting you save enough to retire on 85 percent of your income. That number comes from a study sponsored by the insurance company Aon and is common in financial calculators, such as Fidelity's MyPlan.

"The right replacement rate could be 45 percent, not 85 percent," Kotlikoff argues. "That ratio is extremely sensitive to [the individual's situation], whether you have two kids or one, how old the kids are, whether your spouse works or whether you downsize your home in retirement. They all make a huge difference to the appropriate spending paths over a lifetime."

Parents who are paying college tuition at age 60, for instance, won't be doing that in their 80s, he points out.

Pimping Risk

Exaggerated savings goals lead to what Kotlikoff calls "pimping risk."

"The industry sets targets that are far too high and then says, 'Gee let us help you hit that target -- put your money in stocks,'" he says. "It is true that the probability of making your target will go up, but the probability of having a really bad outcome -- like losing your principal -- will also go up, and so will the fees charged for management."

Noting that three-quarters of active money managers don't beat the market's returns, Kotlikoff and Burns' book recommends that investors choose only low-cost, highly diversified domestic and international index funds -- and be prepared to stomach the market's ups and downs.

"Don't try to time the market because you don't have enough knowledge to do that, and even people with knowledge get burned," says Kotlikoff. "If you're really terrified about the market, buy TIPS [Treasury inflation-protected securities]. You won't do as well over time, but you won't lose your principal."

Asset Diversification vs. Resource Diversification

Meanwhile, if you do hold stocks, age-based allocation strategy scenarios suggest you hold more while you're young, because you have time to ride out the markets ups and downs, and then shift into safer assets like bonds as you age. Popular life-cycle and target-strategy mutual funds are based on this principle.

But Kotlikoff and Burns argue that investors should focus on diversifying their overall resources, not just their assets. Consider a 60-year-old who has $20,000 in assets and $20,000 a year in Social Security income. The latter is equivalent to holding $1 million in inflation-indexed bonds, with a guaranteed annual income stream of 2 percent of the principal, Kotlikoff notes.

"If you take the $20,000 in assets and concentrate it into stocks you will still be highly undiversified -- you are wildly into bonds," he argues. "So concentrating your assets in stocks is the thing to do."

Thus the 60-year-old with guaranteed Social Security payments should hold more stock than someone like me (in my 40s), because as a freelancer my income is more uncertain and I also face more potential liquidity constraints, Kotlikoff says. In their late retirement years, people should dramatically cut back on stocks, because that's when health care expenditures are most uncertain, he adds.

Critical Choices

"Spend 'til the End" also recommends people "price their passions," or calculate the living-standard effect before they get married, have multiple children, divorce, or move to a big city. For instance, the book extols the virtues of living in Cedar Rapids, Iowa (advice clearly conceived before the recent floods), because its low-cost environment provides a 78 percent higher standard of living than Seattle, and 34 percent higher than Tampa. (Stronger housing appreciation in the latter cities doesn't offset other costs, the calculations show.)

"It's important to make these choices ahead of time, to think about what really makes sense in terms of everything you want, because people do make critical, life-altering geographic decisions," Kotlikoff says.

I've actually thought of moving to Iowa (usually after my property tax bill arrives) because I have family there. My husband and I could probably retire 10 years earlier if we sold our home and headed to the Midwest. But living near New York City is an important part of our emotional living standard -- we have family here, too. And I can't fathom the rise in living standards required to get my husband to give up his Giants tickets.

Sometimes, maximizing your self-interest goes beyond calculators. In this case, I'd prefer to leave the price of my passion out of the equation.