Beware of Financial Plannings Misguided Rules-of-Thumb

Lacking better insights, financial planners cling to rules of thumb, such as allocating a percentage of assets to fixed income based on a client’s age. More recently, those rules have been institutionalized through products like target-date funds, which maintain a fixed glide path for all investors. But new research has led to the development of software products that allow advisors to easily improve on the suboptimal outcomes to which clients were previously destined.

Retirement income planning is a growth industry for advisors and a popular subject for academic research. Unfortunately, there is little communication between the academic community and those providing advice for clients. Planning can be improved if we can bridge this gap. I'll discuss advantages of the approach advocated by academic economists and highlight new software that demonstrates its value.

Life-cycle planning

Academic research on retirement income can be traced to the work of economist Frank Ramsey more than 80 years ago. Many prominent economists have been involved since, including Nobel Prize winners Paul Samuelson, Edmund Phelps, Franco Modigliani, Robert Merton, and William Sharpe. Their work has focused on the full life cycle — not just retirement, but accumulation as well – hence the term "life-cycle planning" that describes their recommended approach.

Unfortunately, this research has had little impact on the practice of financial planning. Much of the work makes heavy use of mathematics and uses concepts familiar only to economists, making it inaccessible to many advisors, who continue to rely on inferior rules-of-thumb.

Financial planners have produced their own less technical retirement income research, beginning with Bill Bengen and the "4% Rule" in the early 1990s, with later refinements by Bengen and other planners. Most of the financial planning software in use today is tied to this "practitioner approach" – the sole exception being ESPlanner, which is based on life-cycle planning and was developed by Boston University economics Professor Laurence Kotlikoff and colleagues. Robert Huebscher provided a summary of key features in this 2011 Advisor Perspectivesarticle, and more details are available at the ESPlanner website.

Others have attempted to bridge the gulf between academics and practitioners. Boston University Professor Zvi Bodie has produced several articles and papers in which he presents life-cycle planning in user-friendly terms. An example is a paper with Jonathan Treussard and Paul Willen contained in the CFA publication, The Future of Life-Cycle Saving and Investing, which contains the papers from a 2006 conference that Bodie organized. York University Professor Moshe Milevsky has also been involved in bridging the divide, including his 2010 paper with Huaxiong Huang, Spending Retirement on Planet Vulcan, in which they offer practical advice for retirement income planning based on academic research. From the practitioner side, financial planner Paula Hogan discussed life-cycle finance in a 2007 paper in the Journal of Financial Planning.