Monday, September
6 2010
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Monday, September
6 2010
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Announcing a new acquisition!!
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What's New at Forte for the year 2006 October 2006 - Is Conventional Planning Right for You? By David W. Henion CPA 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 Page 2/
Conventional Planning 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. October
2006— This column is produced by the Financial Planning Association, the
membership organization for the financial planning community, and is provided
by David W. Henion, a local member of
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