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BusinessWeek: November 15, 1999 |
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BusinessWeek Investor: Financial Planning
Planning a Smooth Financial Ride Economists offer their own brand of advice
The problem is that there is no standard for what's "best" in financial planning. So the responsibility of choosing a plan falls on the client, who is swimming in uncertainty. Wouldn't it be nice if there were some kind of rule to go by? Economists think they have one. It's known as life-cycle smoothing. It aims to determine the highest possible standard of living that you will be able to maintain for the rest of your life. If you live too well today and save too little, your living standard will have to drop in the future. That's bad. On the other hand, if you deprive yourself too much now, then either you'll leave your kids richer than you intended or you'll spend like crazy in your old age. That's not ideal, either. The reason for trying to keep your standard of living as steady as possible throughout your life, according to economists, is that really good times never quite make up for really bad times. Smoother is better. MORTGAGE FALLBACK. That simple idea has powerful consequences. First, it emphasizes that saving is not an end in itself; spending is. Saving is good only insofar as it helps you to even out your living standard over a lifetime. For instance, it doesn't make sense to starve yourself when young for the future benefit of your old and rich self. Life-cycle smoothers are also skeptical of the financial planners' motto that you should "pay yourself first," by giving top priority to savings goals. The problem is that by locking in savings targets, spending becomes the swing factor, rising and falling erratically as income and expenses vary. To economists, spending is the main event, not an afterthought. Three economists--Laurence Kotlikoff of Boston University, Douglas Bernheim of Stanford University, and Jagadeesh Gokhale of Solon, Ohio--have incorporated these concepts in a new software package called Economic Security Planner, which is available at their Web site, www.esplanner.com. In commercial terms, the $49.95 ESPlanner is a mite. Only about 70 copies have been sold. But its approach to financial planning profoundly challenges well-known programs such as Intuit Quicken Deluxe 2000. The differences are illuminating, even for people who will never touch a planning program. ESPlanner starts with the idea that you want to die broke, except for money you've set aside for bequests, an emergency fund, and, in most cases, the equity in your house. To guard against outliving your assets, it advises you to set your expected age of death high--the default is 95--and to keep your house debt-free so that you can mortgage it if you survive longer. Then comes the plan. Using your typed-in financial vital statistics, ESPlanner produces the annual levels of consumption and savings that give you the smoothest possible lifetime standard of living. This is no small bit of math: Even a high-powered personal computer takes about 45 seconds to spit out a plan for a married couple. For many households, their living standard will still come out lower when they're young than when they're old, which is less than ideal under the smoothing theory. This is usually because most people face a "borrowing constraint," limiting how much they can borrow against future income to raise their present standard of living. Economists are acutely aware of the difference between a household's consumption and its standard of living: As children are born, for instance, it takes more spending to maintain the same standard of living. Most planning programs don't prompt users to raise and lower their consumption as their household grows and shrinks. ESPlanner does. Its formula generates the correct level of consumption for each period--something that takes hours and hours of diddling in other programs. THE STORK FACTOR. ESPlanner and Quicken can produce quite different results. Kotlikoff, Gokhale, and Mark Warshawsky, research director of the TIAA-CREF Institute, laid them out in a working paper published in August by the National Bureau of Economic Research and available on its Web site, www.nber.org. (Their comparison was with Quicken Financial Planner, a program that has since been rolled into Quicken Deluxe 2000.) In one scenario, "Jane" and husband "George" have one child in 1997 and another in 2001. Quicken doesn't automatically adjust spending for the size of the household. ESPlanner has a spending rise when the children are born, then has it drop back when the kids leave home. That leaves less money for savings in the early years: ESPlanner recommends just $3,000 in annual savings at first, opposed to $7,300 as recommended by Quicken. Executives at Intuit are probably not ecstatic over having their best-selling Quicken program compared with one that has sold 70 copies. Daniel Olsen, lead product manager for Quicken for Windows, said that he had not heard of life-cycle smoothing and asked: "Is the average American going to understand these high-powered concepts?" Quicken is trying to make matters simpler and no longer offers Quicken Financial Planner as a stand-alone program. "The product was really popular with do-it-yourselfers. But most people don't plan that way. You had to pour in lots of data before you got anything useful," says Olsen. Instead, Quicken 2000 has a financial-planning feature designed to allow people to budget for particular goals, such as college or retirement, without having to put together a comprehensive plan. HOG FOR DATA. To Kotlikoff, though, setting savings targets in the absence of an overall plan is "going even further in the wrong direction." When they're not dinking around with financial-planning software, Kotlikoff says, people intuitively follow life-cycle smoothing precepts. They save less when money is tight. And if they get a windfall, they typically save most of it. ESPlanner is not likely to take the world by storm. It is somewhat dense and requires lots of data. Fellow academics, however, have rallied to it. The Web site features endorsements from two top economists at Massachusetts Institute of Technology: Stephen Ross and Nobel laureate Franco Modigliani. Ross even goes so far as to say that "those who fail to use it do so at their peril." Most financial-planning software is scrupulously neutral about the choices that users make. The programs simply take what they're given and project the expected consequences of a particular option. Kotlikoff and company have stronger opinions about what's right and wrong. What's right, by their lights, is life-cycle smoothing. Through efforts such as theirs, a concept that economists have embraced for years may finally start penetrating the world of financial planning. Return to top | |
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 TABLE Financial Planning: An Economist's Approach Economists differ sharply from conventional financial planners in their approach to saving for life's needs. Key economic concepts: -- Saving money is not inherently good. Spending is. The purpose of saving is to enable a high level of spending over a lifetime. -- Aim to "die broke." Spend all your assets except those set aside for bequests, an emergency fund, and maybe the equity in your house. -- Try to keep the same standard of living throughout your life. This usually means saving less when you're young and poor. Return to top Fear Not. Shelter Stocks, Not Bonds John Shoven, a Stanford University economist, exploded two myths of personal investing in a National Bureau of Economic Research working paper this past March. Myth No. 1 is that tax-conscious investors should keep bonds in tax-sheltered accounts and stocks in unsheltered accounts. Myth No. 2 is that risk-averse, long-term investors should invest heavily in bonds. Start with the question of where to put stocks and bonds, assuming that you want to hold both and that you have both a tax-sheltered account such as a 401(k) and an ordinary, unsheltered account. The typical financial planner might advise putting bonds in the sheltered account because interest on corporate bonds is taxed more heavily than long-term capital gains on stocks. NASTY BIT OF NEWS. The first problem with that idea is typical actively managed equity mutual funds produce returns that are quite heavily taxed after all. They throw off lots of dividends and capital-gains distributions. Second, not all bonds are taxed hard: Municipal bonds are exempt from state and local taxes. Third, since there's a limit on your annual contributions to a tax-sheltered account, it makes sense to keep it for the asset that's likely to grow the fastest once it's inside--namely, stocks. It's better to shelter a big, fast-growing portfolio of stocks than a small, slower-growing portfolio of bonds. Shoven's advice: stocks in the shelter, muni bonds outside. Shoven's recommendation changes when your equity mutual fund is managed to keep taxes extremely low: If only one-sixth of your return comes from dividends and long-term capital-gains distributions, then it does make sense to put stocks outside the shelter and bonds--corporate bonds--inside it. To check Myth No. 2, Shoven ran tens of thousands of computer simulations of the future performance of stocks and bonds, assuming they were properly allocated between sheltered and unsheltered accounts. His average forecast was for stocks and bonds to do about the same in the future as they have over the past 70 years, but in some of the projections they did much better or far worse. In a good 30-year stretch, stocks do much better than bonds; in a very bad 30-year stretch, they do only a little worse. In other words, long-term investors who go heavily into bonds are surrendering the likelihood of huge gains from stocks in exchange for the pale assurance that if things go really bad, they will do only slightly better than if they were heavier into stocks. Shoven says an investor with a 30-year horizon who simply wants to maximize return should be 100% in stocks. Someone who is moderately risk-averse should be 70% in stocks, 30% in bonds. Even a very risk-averse person--who wants to minimize the downside of a scenario worse than 99% of all possibilities--should be 60% in stocks and 40% in bonds. Shoven, 52, says his portfolio is 80% to 90% invested in stocks. Return to top |
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