There’s more to financial plans than calculators

Published 8:40 am Thursday, February 2, 2012

Do online interactive financial planning models really help people decide how much to save, to insure and to invest in stocks and other assets? 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 at financial institutions’ websites. 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. More complex ones perform simulations and weigh factors such as household size and composition, income, wealth, desired retirement date, expected inflation rate, expected asset returns, attitude towards risk, etc.

These “Monte Carlo” simulations are an analytical tool for modeling future uncertainty. In layman’s terms, it’s a computer program that examines thousands of market environments and returns and spits out ranges of possible outcomes.

But many of these models are seriously deficient, according Laurence Kotlikoff, professor of economics at Boston University and president of 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 to set retirement spending targets. Many 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, as small as 10 percent, can lead to enormous mistakes in recommended saving and insurance levels and to major disruptions in retirement living standards.

There are many reasons why small targeting mistakes lead to such bad saving and insurance advice and such large consumption disruptions, Kotlikoff said. 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 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 exhausting money. Most of these simulations assume that households make no adjustment to their spending regardless of how well or how poorly their investments do. But consumption smoothing dictates such adjustments and, indeed, precludes running out of money. 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 generally serious shortcomings of targeting spending, Kotlokoff says online calculators typically offer remarkably simple advice geared to speed households through the planning process.

But quick and simple doesn’t necessarily spell helpful, Kotlikoff says. In fact, many online calculators lead to dramatic over-saving thanks to retirement-spending targeting mistakes.

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. 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.”

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 it.

Erin Eddins is a chartered financial consultant, a member of the Financial Planning Association and is a certified financial planner professional. She can be reached at erin.eddins@standard.com or 425-212-5986. This column is produced by the Financial Planning Association.