FOR RELEASE:
March 10, 2008
CONTACT:
Heather Almand
Director of Public Relations & Communications
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DENVER, CO….March 10, 2008…Is there a better way for the average family to smooth out and raise their standard of living over their lifetime than current conventional financial planning recommends? Yes, argues a well-known economist in the March 2008 issue of the Journal of Financial Planning, published monthly by the Financial Planning Association® (FPA®).
Laurence J. Kotlikoff, Ph.D., a professor of economics at Boston University in Massachusetts advocates a long-standing economics approach to household financing based on the concept of “consumption smoothing.” This approach is designed to calculate appropriate annual spending amounts for households in order to smooth and ideally raise a family’s standard of living from year to year—so they “neither squander nor hoard one’s spending power, but rather spend it smoothly over time.”
Conventional financial planning, argues Kotlikoff, sets distant accumulation goals, usually for retirement, and then either asks households to set their own spending targets, uses current spending to establish targets, or relies on retirement “replacement rates” to set targets. While this approach is also designed to smooth out a household’s standard of living, Kotlikoff contends that it often achieves the opposite results. He says the approach involves more guesswork, and even small targeting mistakes spread over 40-plus years can result in miscalculations in savings rates, leaving the family with either too much or too little money for retirement and creating an abrupt change in living standards.
Kotlikoff says a key to the economics approach of consumption smoothing is the use of a mathematical technique called dynamic programming. This technique answers the difficult challenge of how to smooth your spending out over a long time: What you should spend today depends on what you earn and spend tomorrow, and the day after that, and so on.
“Stated differently,” writes Kotlikoff, “knowing what you should do today requires a game plan for tomorrow.”
Such questions involve incorporating a host of future variables such as what you might receive from Social Security years from now (in part a function of the jobs you choose), whether you have children, whether they go to college, when you plan to retire, borrowing constraints, future tax rates, or whether you hope to buy a vacation home someday.
“Each of these variables demands consideration for each and every future year under each and every survival contingency,” writes Kotlikoff.
The economist provides an extensive example involving a 35-year-old couple making $100,000 a year, with two young children. He calculates that in order to smooth out their living standard, they need to spend on consumption each year (measured in today’s dollars) $41,395 when both children are home, $35,405 after the first child heads to college, and $30,345 after the children have graduated and the mortgage is paid off.
But using the more conventional targeting approach of financial planning, says Kotlikoff, citing numbers from the “national savings rate guidelines” calculated by Ibbotson et al. in an article in the April 2007 issue of the Journal of Financial Planning, the couple would have to save so much that they would be able to spend only $23,800 instead of $41,395 when both children are home.
Until recently, using dynamic programming to calculate such a “lifetime spending plan” was relegated to academic research, says Kotlikoff. But advances in computing power have allowed accessible software to be developed which can be used at the financial planner level.
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