Is Conventional
Planning Right for You?
Do online
interactive financial planning models really help people in deciding how
much to save, to insure, and to invest in stocks and other asset classes?
These models vary in complexity and in level of detail, according to a
recent Boston University School of Management Conference on the Future of
Life-Cycle Saving & Investing.
Many of these models
are available for free on the Web sites of financial institutions. The
simplest are "calculators" that tell the user how much to save
each year at an assumed rate of return in order to accumulate a desired
future sum at an assumed retirement date. They make doing sensitivity
analysis quick and easy. The more ambitious ones perform Monte Carlo
simulations and take into account a relatively large number of factors,
including household size and composition, income, wealth, desired
retirement date, expected inflation rate, expected asset returns, attitude
towards risk, etc. A Monte Carlo simulation is an analytical tool for
modeling future uncertainty. In layman's terms, it's a computer program
that first examines thousands upon thousands of market environments and
market returns and then spits out ranges of possible outcomes or success
rates.
But many of these
models, at least from the perspective of economic theory, are seriously
deficient according Laurence J. Kotlikoff, Professor of Economics, Boston
University and President, Economic Security Planning.
In his recent paper,
"Is Conventional Financial Planning Good for Your Financial
Health?" Kotlikoff notes that economics teaches us that we save,
insure, and diversify in order to mitigate fluctuations in our living
standards over time and across contingencies.
While the goals of
conventional financial planning appear consonant with such consumption
smoothing, the actual practice of conventional planning is anything but.
Consumption smoothing is the notion that consumers will spend on average
70 to 80 percent of their pre-retirement income per year once in
retirement. Conventional planning’s disconnect with economics begins
with its first step, namely forcing Americans – in the absence of a
financial planer - to set their own retirement spending targets. In many
cases, experts say Americans are ill-equipped to establish how much they
will spend in retirement.
Setting spending
targets that are consistent with consumption smoothing is incredibly
difficult, making large targeting mistakes almost inevitable, Kotlikoff
notes.
But even small
targeting mistakes, on the order of 10 percent, can lead to enormous
mistakes in recommended saving and insurance levels and to major
disruptions (on the order of 30 percent) in living standards in retirement
or widow(er)-hood.
There are many
reasons why small targeting mistakes lead to such bad saving and insurance
advice and such large consumption disruptions, according to Kotlikoff. For
instance, the wrong targeted spending level is being assigned to each and
every year of retirement. In addition, planning to spend too much (or too
little) in retirement requires spending too little (or too much) before
those states are reached. This magnifies the living standard differences.
Conventional
planning’s use of spending targets also distorts its portfolio advice.
Given a household’s spending target and its portfolio mix, standard
practice entails running Monte Carlo simulations to determine the
household’s probability of running out of money. Most of these
simulations assume that households make no adjustment whatsoever to their
spending regardless of how well or how poorly they do on their
investments. But consumption smoothing dictates such adjustments and,
indeed, precludes running out of money; i.e., ending up with literally
zero consumption. It is precisely the range of these living standard
adjustments that households need to understand to assess their portfolio
risk. Conventional portfolio analysis not only answers the wrong question;
it may also improperly encourage risk-taking since riskier investments may
entail a lower chance of financial exhaustion thanks to their higher mean
return.
In addition to
exposing the general and generally serious shortcomings of targeting
spending, Kotlokoff says online calculators typically offer remarkably
simple advice geared to speed households through the planning process in a
matter of minutes.
But quick and simple
doesn’t necessarily spell helpful, according to Kotlikoff. In fact, many
online calculators lead to dramatic oversaving thanks to
retirement-spending targeting mistakes ranging from 36 to 78 percent too
high.
For his part,
Kotlikoff suggests: "None of us would go to a doctor for a 60-second
checkup. Nor would we elect surgery by meat cleaver over surgery with a
scalpel. And any doctor who provided such services would be quickly
drummed out of the medical profession. Financial planning, like brain
surgery, is an extraordinarily precise business. Small mistakes and the
wrong tools can just as easily undermine as improve financial
health."
At the end of the
day, most experts suggest that using a financial planner can eliminate the
need to use Web-based calculators and run the risk of saving too little
for retirement or spending too much in retirement.
November 2006— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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