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Are you saving too much?

One economist worries you may be spoiling the best years of your life by scrimping and saving for retirement. The other thinks your golden years could cost more than you've bargained for.

By Yuval Rosenberg, Fortune Magazine contributing writer

(Fortune Magazine) -- How long will you live? What will you eat during retirement? Are your adult children secretly planning to move back home?

If you're stumped, you get the idea of how complicated and fraught with uncertainty saving for retirement can be.

Laurence J. Kotlikoff (left) thinks people are over-saving. Jonathan Skinner (right) says better safe than sorry.

Financial planners often set savings targets based on replacing 70% or more of pre-retirement income. Yet recently a cadre of economists have challenged that approach, suggesting it often results in wildly misguided targets.

Foremost among those fighting the orthodoxy is Laurence J. Kotlikoff of Boston University. In a 2006 paper, Kotlikoff found that online savings and insurance calculators from the likes of Fidelity and TIAA-CREF can tell people to save five times too much. (Kotlikoff admits he is not an impartial observer, having developed his own planning software called ESPlanner.)

On the other hand, Dartmouth economist Jonathan Skinner - a former student of Kotlikoff's - used ESPlanner for a forthcoming paper and concluded that retirement-savings requirements may be significantly higher than Kotlikoff suggests.

Fortune's Yuval Rosenberg asked the two professors to sound off on the topic. What follows are excerpts from their debate.

FORTUNE: Professor Kotlikoff, you call much of financial planning "malpractice" and say that online calculators are telling people to save way too much. Why?

KOTLIKOFF: The basic problem here is that they're using a replacement-rate methodology, which makes mind-bogglingly stupid assumptions, including that the spending you do before retirement will continue right through age 100.

And by that I mean all the spending you do on your kids, all the mortgage payments you're making before retirement. So it's not surprising it comes out with crazy recommendations.

For a lot of middle-class households, following those recommendations and trying to get an 80% replacement rate would involve starvation.

Then the second stage of the malpractice is that after you've recommended far too much saving, you then induce them to invest in riskier securities to raise the probability of making this target.

FORTUNE: But isn't it better to save too much than too little?

KOTLIKOFF: I'm talking here about these companies recommending five times too much saving and five times too much life insurance. So the risk there is that people will squander their youth rather than their money.

They'll save like crazy, and they'll either die too young to enjoy their savings or they'll not die and have spent all this money enriching life insurance agents.

FORTUNE: Professor Skinner, you used Larry's ESPlanner and concluded people aren't saving enough.

SKINNER: A mind-numbing number of variables really matter a lot. Let me give you an example. Let's say you take Larry's program and you set up a couple with no kids and run the numbers. Now let's add two kids and future college costs of about $160,000 combined.

Well, actually your required wealth drops by a quarter of a million dollars because with kids you get rid of the caviar and fine wine and you go to peanut butter.

But the model assumes, then, that you stick with peanut butter throughout your retirement. It assumes you won't celebrate your kids' leaving by breaking out the caviar or by saying, "I've been deprived for so long - now I want to go on a cruise."

It is possible to change the program's assumptions, but I think there are a lot of implicit default parameters in the model that really require almost a Ph.D. in economics or demography to understand.

To make it even more complicated, it's also under this veil of uncertainty. You don't know whether you're going to have to retire at 63 or whether you can work to 70.

FORTUNE: Let's talk about health care. How can the average person know how much they'll need?

SKINNER: The thing that has worried me the most is that out-of-pocket health-care costs have generally grown at about the same rate as what you would call in-pocket health-care costs - the things covered by insurance.

Also, more and more employers are dropping retirement health benefits. Some estimates from the Employee Benefit Research Institute suggest that for people who are now 55, by the time they're 65, they'd better accumulate $400,000 for supplemental coverage throughout their retirement.

And this doesn't even include the prospect of nursing homes, which are generally not covered under Medicare. So again, you could put that number into the program, but typically people don't because if they did they would be saving a lot more.

KOTLIKOFF: Let me just respond. Most low- and middle-income households are going to rely on Medicaid. To save for $150,000 a year of medical expenses for five years is just not possible.

If they're not buying long-term-care insurance, most people will rely on Medicaid (including a majority of those in nursing homes). So I think we can easily overstate these expenses.

FORTUNE: So is there anything one can do to better prepare for retirement?

SKINNER: I agree that a lot of people are constrained. My own impression is that for people in their 20s and 30s the name of the game is to max out on your 401(k) contributions or set up a supplemental savings program that you can do through your employer and start thinking about housing equity.

And it's really only in your 40s and 50s that people should be focusing on saving a lot outside of houses and 401(k)s.

KOTLIKOFF: I think the real story here is that desktop computers are becoming sufficiently powerful that we can now move [economic modeling] work from pure research into people's households. People can now price out their lifestyle choices.

How much will getting divorced cost me? Or having another kid? In eight seconds you can figure out how to raise your living standard by 10% or 12% by, say, deciding to delay taking your Social Security. It's a gold mine.

SKINNER: I think Larry is pretty optimistic here, but he's also a really smart guy who knows what questions to ask the computer. So the concern is that the average Joe is going to sit down with this really scary program and is basically going to go with the defaults and may get an exact number, but one which carries all of these implicit assumptions in it that he may not agree with.

When it comes to a choice between more stuff today and future piece of mind, I tend to go for future peace of mind. Maybe I'll end up saving too much, and if so, I would be happy to lend some money to Larry.  Top of page