Many people avoid confronting their finances out of fear—fear that they’re too far behind or fear that dealing with them will be arduous. That’s led to something of a “personal finance is not complicated” movement in the advice-giving community.
A recent New York Times article and a new book attempt to prove the proposition by listing a few simple rules of thumb for investing on a notecard. Top of the to-do-list: max out your retirement savings accounts. Lower on the list are other forms of saving like an emergency fund (it’s not clear the advice is listed by order of importance—if not it’s a major oversight because prioritizing financial goals is as important as having them). Maxing out your retirement account sounds sensible—we should all save more for retirement—but for the majority of people it’s not great advice.
Most years I don’t contribute the maximum to my retirement accounts ($18,000 to a 401(k) if employed, and $5,500 to a traditional IRA). Instead, I contribute only to take full advantage of my employer match (otherwise you are leaving money on the table). In jobs where there wasn’t a match, I didn’t contribute anything at all. The illiquidity turns me off. I still save and invest in stocks, just in other accounts I can access more easily.
That surprises most people. After all, as a pension economist, I spend many hours obsessing over how much money people need to retire. But because of some career choices, I have extremely volatile earnings, which factors into my savings decisions.
Underlying most good personal-finance strategies is what economists call life-cycle theory. It claims the purpose of saving is to maintain a consistent standard of living no matter what life throws at you—job loss, divorce, retirement, etc. Being a good economist, I aspire to smooth my consumption despite large swings in earnings. That has led me to place a high premium on liquidity. Retirement accounts lock up my money until age 59.5, unless I’m willing to pay 10% in penalties to take it out earlier.
My variable earnings aren’t unique. Economists studied over 200 million US Social Security earnings records from 1978 to 2010 and found many people face huge income swings at some point in their career. Income variability decreases with income and age, leaving young and middle-to-low earners the most vulnerable to income risk. The study also found that, odds are, you’ll have more bad years than good, and more bad years as you age.
And there’s reason to believe earnings in the US will become even more volatile in the future. Fewer people work in government or union jobs, which offered steadier wages. Instead, more people work in services, and long job tenure is less common, each of which tend to mean more volatile earnings.
Despite that lack of stability, Americans continue to skimp on liquid savings. A recent survey estimates 63% of Americans couldn’t finance an unexpected emergency that costs between $500 and $1,000. According to data from the Federal Reserve Survey of Consumer Finances, median liquid savings (checking, money market, and savings accounts) is only about $3,000. About 25% of Americans have less than $500 in the bank. Lack of liquid savings in part, explains why so many people take money out of their retirement accounts early and pay penalties that eat into their meagre savings.
True, there’s a tax advantage to stashing earnings in a 401(k). I don’t pay taxes on money I put into the accounts today, but I will when I retire (assuming it’s not a Roth account). Because my taxes are higher as a worker than as a retiree (when I don’t have labor earnings anymore), the tax rate I’ll pay on retirement account money is lower, saving me some taxes. But tax savings is not guaranteed. Entitlement spending is projected to be a major budget strain around the time I’ll retire. In order to pay for it, the government might increase my future taxes.
Many households are just getting by and face more risk than ever before. Financial advice that accounts for their needs wouldn’t advise them to tie up what little they have in an illiquid asset. Financial advice needn’t be complicated, but it also should be better.