A Better Way to do Financial Planning

Larry Kotlikoff

Simplicity is dangerous when it comes to financial planning. Easy-to-use tools that project your retirement savings based on minimal inputs such as your income and savings rate amount to a “bait-and-switch,” according to Larry Kotlikoff, a Boston University professor of economics. To properly prepare for retirement, one should focus on maintaining a constant standard of living throughout their life – what economists call consumption smoothing.

Consider this retirement planning web site. It takes your anticipated retirement age, monthly savings amount, and investment style (conservative, growth, aggressive, etc.) and determines the size of your nest egg at the time you retire. According to Kotlikoff, this approach leads clients to set unrealistically high retirement goals and pushes them into inappropriately risky investments. Disappointing or disastrous results ensue – but not for the product provider, which has earned its fees on the failed investments.

“Traditional financial planning software has no interest in consumption smoothing,” he said. “It's all focused on product sales.”

Kotlikoff, who is also a columnist for Bloomberg, has built a company, Economic Security Planning, Inc., which offers financial planning software (ESPlanner) based on consumption smoothing, a far more complex methodology than traditional approaches, but Kotlikoff’s software produces what he considers much more realistic annual spending, saving, and insurance recommendations for clients.

Kotlikoff spoke with me a couple of weeks ago about his approach – and about his “purple” tax proposals, which I wrote about in a previous article.

Behind consumption smoothing

It’s not just economic theory, but common sense, that dictates that people should be focused on trying to smooth their standard of living, Kotlikoff said. “You don’t want to splurge today and starve tomorrow,” he said, “or vice versa.”

Indeed, over-saving is also a big problem for some households, Kotlikoff said. There’s no point in a miserly lifestyle, he said, when one’s earnings and assets can support a much more enjoyable standard of living.

Consumption smoothing requires you to insure as well as to save. Insurance is necessary to protect against periods when you have insufficient resources. When he spoke of insurance, Kotlikoff was not only referring to traditional products, such as life insurance, but also to an investment approach that limits one’s potential downside losses.