Economics-Based Versus Conventional Financial Planning

I have a big problem with conventional personal financial planning. Unfortunately, it has little connection to what basic economics and, indeed, common sense recommends. As a consequence, it produces inappropriate spending, saving, insurance, and investment advice.

But before laying out my concerns, I need to disclose a major conflict of interest. My company,, markets economics-based personal financial planning software, which produces, I believe, far more appropriate guidance than conventional planning. Given this conflict, you may want to take what I say with a grain of salt. This said I believe my reaction to conventional financial planning is that of economists in general.

This is not meant as an indictment of financial planners or the financial 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 planning. 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 adopted modern tools. Consequently, it continues to provide bad advice.

Let me clarify economics-based financial planning and then explain my concerns with conventional planning. Economics-based financial 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 says two things – don’t eat all your eggs at once and don’t put them all in one basket.

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 tested consumption smoothing with my youngest son David when he was 10. I bought 20 delicious chocolate cupcakes, waited till my wife was out of the house and then sat him down in front of all 20. “David,” I said. “Mom’s gone. Eat as many as you want.” It was late in the afternoon, so David was hungry. The first cupcake disappeared in a nanosecond. The second, in 30 seconds. The third took two minutes to reach his stomach. Midway into the fourth, I said, “David. Mom’s gone. Have as many as you want.” At this point, he said, “Dad. Let’s save the rest for tomorrow.”

This is Fisher’s theory in a nutshell – spread your consumption, i.e., your discretionary spending power, over time, indeed, 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 less – a lot less. Buying insurance reduces your spending in the good state (no loss, but you’re 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 planning, what a household should spend (on a discretionary basis) today such that it can spend the same (maintain its living standard) through time. (Spending here references discretionary spending after the household meets all its housing, taxes, and all other off-the-top expenses.) Instead, it asks households to guess their retirement spending, pushing them to use a 75 to 85 percent replacement ratio. The problem here is that no one can guess the answer to this question. It’s immensely complicated. And using a rule of dumb is no alternative.

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 percent mistake in the post-retirement spending target can produce a 30 percent disruption in living standard when the household reaches retirement. The reason is that the 10 percent 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 crude target practice, is guaranteed to deliver the wrong saving advice.

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 time-varying portfolio holdings. Along each Monte Carlo simulation path, 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 Monte Carlo simulations assume the household will spend, in retirement, the same amount (the target they set when they did their planning – potentially decades earlier) year after year regardless of whether they hit the jackpot in the market or lose virtually everything on the market. No one in his right mind behaves like this. Instead, as economics predicts, they adjust their spending up or down depending on how their 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 portfolio advice.

Through no fault of its own, the financial industry landed, decades ago, on a planning methodology that, unfortunately, 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 planning represents a free lunch. It secures households’ living standards through time and the resulting peace of mind can be worth its weight in gold.

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