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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 to 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 planner — 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 Don McCarty of
Financial Decision Partners, a local member of the FPA.
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