Economics-Based, Long-Range Planning A More Valid Approach to Retirement Planning

By Scott Neal, CPA, CFP

There are many approaches to financial planning. Today, the most popular are typically divided into two: 1. conventional goal seeking and 2. the economics’ approach. It is important for you to know the difference and to understand which one your financial advisor is using and why he or she may choose one over the other. At D. Scott Neal, Inc., we view these two approaches as different tools in our planner’s tool bag. Just as in carpentry and mechanics, one must use the right tool for a particular job in order to achieve optimal results.

Conventional financial planning focuses on how much you need to set aside for a specific future goal, i.e. buying an asset such as a car, a boat, putting a down payment on a house, or funding a child’s college education. Each targeted objective has a specific, usually very short-lived time frame for getting it done. Note the nature of the transaction. You save money for some period of time to spend it rather quickly. Of course, college funding requires expenditures over 4 or 5 years, but that is still a relatively short period of time compared to retirement, for example. Unfortunately, many financial planners use the same approach to plan for retirement or to produce other long-range plans. That is like using a wrench to drive a nail or a hammer to change a flat tire.

The primary reason that we believe the traditional approach is such a poor tool choice for retirement is two fold: 1) the length of time that one expects to be retired and 2) the incredible number of variables that must be taken into consideration to make the projection relevant over that period of time. Recall that the traditional approach asks you to set a date for retirement (some will even give you the opportunity to set a date for semi-retirement prior to full retirement). Further, it asks you to estimate the amount that will be needed from savings each year. It then calculates the total sum that will be needed on that date that will enable you to live long and prosper. Make a mistake in the calculation or estimation of any of these variables at age 65, and by the time you reach old age, the error will be huge.

We argue that this approach to financial planning for retirement (or any other long-lived objective) is better for the advisor than it is for you, the client. The advisor whose fee is determined by assets under management has a clear and compelling interest for you to save even more than may be necessary. For example, if you ignore any one resource available to you (i.e. social security or funds from downsizing your residence) before or during retirement, you will automatically over-save. Overestimate the amount needed in retirement and you will over-save. Over-saving is almost as bad as under-saving because it comes at the expense of some part of your living standard today. Let’s be very clear! We don’t intend to underplay the importance of saving. We know that setting aside money while working in order to provide resources for the years when you do not earn money is vital for most of us. Underestimate the need at retirement, and you will under-save and run the risk of outliving your money. The point is that you do not have to rely on guesstimations with the economics’ approach to financial planning.

Most of our clients have told us that their very real concerns about retirement are two fold: 1) outliving their money and 2) having to reduce their living standard as they age. When pressed on the issue, they are also concerned about having to reduce their current living standard in order to fund what some financial advisor or online tool has told them is the right amount to save. For some this is a valid concern; for others it is not.

The answer to most of these questions (and a host of others) can be found in the economics’ approach to financial planning. It focuses on planning for a smooth living standard for a long enough period that will cover most any lifetime. The approach has been popularized by Laurence Kotlikoff, economics professor at Boston University, and described in his book, Spend ‘til the End, but is built on research by none other than the late Irving Fisher of Yale University. The concept of consumption smoothing has been around for over a century, but only now have we had the computational power for it to be used efficiently. Our firm uses Kotlikoff’s program, Economic Security Planner (esplanner).

It is vitally important to understand that one’s living standard is supported by how much he or she spends each year, not how much is in the bank at any given point in time. A restatement of our clients’ concerns above implies that most of us would like to have minimal disruption to our living standard throughout the remainder of our lives, even if we have very long lives. In other words, we would like our living standard to be smooth, or perhaps enhanced because of the decisions that we make today. Of course, economists tell us that by operating in an inflationary economy such as ours, the cost of living will go up. More dollars will be required in the future to maintain the same living standard enjoyed today.

Smoothing your living standard means spreading your spending power evenly over time, so that you never have to worry about running out of money, even as the amount is adjusted for the rising cost of living and even as earnings stop at some point.

Consumption smoothing does take into account the law of diminishing returns. That is, economists believe that one can have too much of a good thing and that sooner or later another dollar of spending does not yield another dollar’s worth of fulfillment. However, it also means protecting your living standard—making sure that it stays relatively steady in good and bad times. In other words, we believe that you do not want to suffer disruptions to your living standard due to adverse changes in income, certain expenses, taxes, government benefits, and inflation. Additionally, you would want to make sure that the added risk of choosing one investment over another is actually worth it in terms of its effect on your living standard.

We acknowledge that financial planning is truly about making decisions. We view our job as one which helps you make better decisions regarding a lot of different financial variables. Thus, we define a better decision as one that provides you with more money to spend for the same effort expended. The first task then is to determine an amount that represents your maximum spending power this year that will remain smooth for the remainder of your life when adjusted for inflation.

Finally, the economics’ approach to financial planning affords you the opportunity to know what it costs to do the things that you really love to do. These may include taking a wonderful but lower-paying job, retiring sooner rather than later, buying a vacation residence, moving to a different climate, contributing to charity, or any other passion that may be uniquely yours. It is easy to quantify the immediate cost of a vacation home, but what if you could know the long-term effect of that decision on your living standard for the rest of your life. Using the economics’ approach, we can make that determination.

So how do we do this?

1. Identify and quantify current and future resources

First of all, we consider the amount of your resources that would, sooner or later throughout your lifetime, be available to spend to support your living standard. Resources typically consist of:

  • Earned income from now until retirement.
  • Gifts or inheritances (but should be included only if they are certain to occur).
  • Both income and principal (if you are willing to spend your capital as you age) of investment accounts.
  • Social security.
  • Cash value of life insurance policies.
  • Cash flow generated from the sale of an asset such as a vacation residence or a business interest.

Note: Because you will always need a place to live, we do not consider your primary residence or your personal belongings as assets (resources) that will be used to fund your living standard. You could, however, instruct us that you would be willing to downsize at some future date or even turn to renting, if that made sense. We can make modifications to our analyses based on your specific needs and goals.

2. Identify and quantify special expenditures

There are some things that you will want to be certain get funded even at the expense of your current and future living standard. Typically, these fall into two categories: necessary and discretionary. The necessary may be to pay off existing debts, to fund the cost of long-term care or the premium for long-term care insurance, to fund a certain bequest upon death, or to fund funeral expenses. Discretionary goals can be anything that you dream about. We add the ongoing cost of your housing to these other expenditures, and these make up the “special expenditures” for things that you want to make sure get funded before arriving at the amount available to spend on your living standard.

3. Build a base case scenario

Some will view this as the “most likely” scenario while others see it as the “worst case.” To arrive at the base case, we assume that taxes will have to be paid at the rates that are currently in the law, adjusted for inflation where necessary. To calculate the true maximum sustainable living standard, we assume that at a certain age (we default to age 100 unless you tell us otherwise) you will have all your resources (except for your personal residence) spent. Using dynamic programming we are then able to plan backwards from that target age to your current age to determine the amount of spending that will smooth your consumption adjusted for inflation. Perhaps you can see the complexity of the math that must be involved in such intricate computations. The number that arises from this analysis is the maximum amount of money that you will be able to spend this year that can be adjusted for inflation for each year for the rest of your life.

4. Plan for improvement in living standard

As financial planners, our aim is to help you improve both your financial and personal well-being by working toward finding a higher, smoother, and more rewarding living standard. Once the base case is established and assumptions agreed to, we can then build alternative scenarios to demonstrate the effect of our ideas on your living standard. Some of our ideas have been: 1) increase or decrease funding of a tax-deferred retirement account; 2) convert a traditional IRA to a ROTH; 3) move to a state with lower or no income taxes; 4) downsize residence; 5) pay off debt earlier (or later); 6) start social security earlier (or later); 7) pay back social security and restart at a later date; 8) retire later; and/or 9) annuitize a pension or take a lump sum.

5. Provide decision support with scenario planning

In addition to our planning ideas outlined just above, there are times when clients have particular and pressing questions about their financial lives:

  • Can I afford __________? You fill in the blank.
  • Is working until age 66 really worth it?
  • What is my safe rate of spending in retirement?
  • Am I saving enough to sustain my living standard?
  • Should I accelerate payoff of my debt?
  • Should I have my child borrow money to go to school?
  • How much can I afford to give away to children, grandchildren or charity?

Each question is also a version of: Can you raise your living standard? Can it be preserved? Can it be sacrificed to some extent in order to reach other goals? By now, you can see that each of your financial decisions should be evaluated on the merits of its effect on your living standard, now and throughout the future. Having built the base case, we can then, in very short order, quantify the effect of the decision under consideration. We can isolate the relevant facts and circumstances of that decision into an alternative scenario and recommend whether a certain course of action will increase or decrease your living standard, and by how much. Imagine how you will feel having made a more fully informed decision.