I’ve heard this argument before. I heard it again with respect to armchair economists. If we could solve all our world’s problems from the comfort of our living room, the world would be a better place. This can be construed to my own industry. Simply put, I have an issue with conventional personal financial planning. Unfortunately, it has little connection to what basic economics and, indeed, common sense recommends. Well, at least in conventional planning. As a consequence, it produces inappropriate spending, saving, insurance, and investment advice. Thus our course of financial life planning. Allow me to elaborate.
I want to first state that this is not an indictment of financial planners or the financial planning industry. The methodology of conventional financial planning was developed decades ago before we had high-speed computers, sufficient memory, and the proper algorithms to do economics-based financial life planning. It’s a matter of us catching up with the times. The industry did the best planning it could given the tools it had available at the time. This was target-based financial planning. Unfortunately, the industry never fully adopted the ever increasing array of modern tools.
Let me clarify economics-based financial life planning and then explain my concerns with conventional planning. Economics-based financial life planning stems from Yale economist Irving Fisher’s seminal 1930 book, The Theory of Interest. This book laid out the basis for all of economics’ personal financial theory, namely consumption smoothing. Consumption smoothing essentially says two things that you probably already identify with: don’t put all your eggs in one basket and don’t eat all your eggs at once.
Consumption smoothing is grounded in human physiology. We get satiated as we eat more and more at a given point in time and instinctively want to save for the future. I’ll give you an example of consumption smoothing. Let’s say I bought a dozen delicious butter tarts and sat someone down in front of all of them. My instruction: eat as many as you want. The individual loves butter tarts and he was hungry. The first cupcake quickly disappeared. The second, in 30 seconds. The third took two minutes. Midway into the fourth, the individual said let’s save the rest for another time.
So, the theory in a nutshell is to spread your consumption (i.e. your discretionary spending power) over time over your lifetime. This way you won’t splurge today and starve tomorrow or do the opposite. Also, spread you discretionary spending power over time – good times and bad times. This means don’t invest in just one asset. Doing so will mean high spending when the asset hits and low spending when it doesn’t. That’s consumption disruption not consumption smoothing across time.
So is failing to buy insurance. Take homeowners insurance. If your house doesn’t burn down, you consume more. But if it does, you consume a lot less. Buying insurance reduces your spending in the good state (you’re only out the insurance premium), but raises it in the bad state (thanks to the insurance settlement). All of modern finance and every analysis of insurance begin and end with the assumption and satisfaction of consumption smoothing. The desire to consumption smooth is, by the way, intimately linked to risk aversion. In standard economic models, the more risk averse, the more the household wants to smooth consumption and vice versa.
Now think of conventional planning. It doesn’t figure out, as does economics-based financial life planning, what a household should discretionally spend today such that it can spend the same (maintaining a standard of living) through time. Spending here references discretionary spending after the household meets all its housing, taxes, and all other fixed expenses.) Instead, it asks households to guess their retirement spending, pushing them to use a 75% to 85% replacement ratio. The problem here is that no one can guess the answer to this question. It’s immensely complicated.
If the guess is too high, the household will consume less before retirement and more after. If the guess is too low, the household will do the opposite. That’s consumption disruption, not consumption smoothing. Even a mere 10% mistake in the post-retirement spending target can produce a 30% disruption in living standard when the household reaches retirement. The reason is that the 10% mistake will apply to all potential years of retirement, which, for most households is roughly 35 years. Stated differently, conventional planning, based as it is on extremely rudimentary target practice, is guaranteed to deliver the wrong saving advice. Think of it as target practice at a rifle range, how many of those shots will you miss and how many will hit the target.
Moreover, if life insurance advice is pegged to the household’s recommended current spending, what’s recommended will also be either too high or too low. For survivors, this represents more consumption disruption.
What about portfolio advice? Conventional planning takes a household’s annual pre-retirement saving as given and accumulates this saving through retirement based on rates of return drawn from assumed portfolio holdings. Conventional planning takes the derived wealth at retirement and grows it from there taking into account a) the annual need to cover the targeted level of spending and b) random return draws on assets held in retirement. If the simulation leaves the household with wealth at some assumed end date, the simulation is counted as a success. The share of all such simulations that don’t run out of money is conveyed to the household as the portfolio’s success rate.
There are two huge problems here. First, if the targeted spending is wrong, which it surely is, the probability of success will be wrong, leading to the wrong investment advice. Second, conventional portfolio simulations assume the household will spend, in retirement, the same amount (the target they set when they did their planning) year after year regardless of market performance. The trouble is no one behaves like this. Instead, as economics predicts, people adjust their spending up or down depending on how their investment portfolio performs. This assumption of blindly following some spending target through each and every retirement year regardless of one’s current level of assets is hardly a reasonable basis for providing sound planning advice.
The financial planning industry landed, decades ago, on a planning methodology that systematically disrupts, rather than smooths consumption and that generates demonstrably poor saving, insurance, and portfolio advice. Retaining this flawed methodology is not a path to seeking alpha. It’s the opposite. Seeking alpha means taking advantage of every free lunch. Economics-based financial life planning represents a free lunch. It secures households’ living standards through time and the resulting peace of mind can be priceless. Therefore, financial life planning is Keeping Life Current.