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Investor's Insight - April 10, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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FINANCIAL PLANNING 2.0, PART 3:
WHEN QUICK IS DIRTY
by Scott Burns
Financial Planning 1.0 -- what most of us encounter
through advisers or on the Internet -- meet Financial
Planning 2.0. This eight-part series of columns, writt-
en by Laurence J. Kotlikoff and me, explores the con-
sumption smoothing approach to lifetime personal fi-
nance. While the idea has been developing for nearly a
century, it has taken the power of today's personal
computers to build the necessary tools. When we use
these tools, we find that conventional planning is more
likely to lead us astray than take us to financial se-
curity.
In his day, Andrew Carnegie was the world's richest man.
He was also one of the most humble and generous people
to ever walk the Earth. He attributed much of his succ-
ess to others. Following his dictum -- "The man who dies
rich dies disgraced" -- he donated his entire estate to
charity.
Carnegie was particularly passionate about education and
educators. In 1918 he endowed the Teachers Insurance Ann-
uity Association, now known as TIAA-CREF, to help ensure
the financial well-being of our nation's teachers. Over
the years, TIAA-CREF has done a fine job fulfilling its
mission, not just for teachers, but for the general pub-
lic it now serves. It does high-quality research and de-
livers low-cost investment management.
But we've got a complaint.
The one area where the nonprofit has fallen short is fi-
nancial advice. Here the company seems more concerned
with marketing than with providing sound guidance. Case
in point: TIAA-CREF has not one, but two, life insurance
needs calculators on its Web site.
The Simple Life Insurance Calculator has five questions.
The Detailed Life Insurance Needs Calculator has 20
questions.
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Both calculators ask you how much of the insured's earn-
ings need to be replaced and for how long. They both ad-
vise using a 75 percent income replacement rate if the
household has no mortgage. They advise a higher rate if
it does.
Both calculators solicit your mortgage balance and college
and emergency funding needs. The Detailed Calculator also
asks about household demographics, assets, taxes, inflat-
ion and the rate of return on one's assets.
Neither calculator asks about the surviving spouse's/
partner's current earnings, future earnings or retirement
date. This is remarkable because the fundamental goal of
life insurance is maintaining the household's living stan-
dard. You can't understand insurance needs without knowing
the living standard that needs to be protected. And you
can't calculate the household's living standard without
knowing about all its economic resources -- including those
of the surviving spouse/partner.
The calculators also ignore all Social Security survivor
benefits -- another huge omission. There's nothing about
the survivor's planning horizon, housing plans, pension
benefits, retirement accounts and a host of other factors
that can make a major difference to life insurance needs.
Does it matter? Yes.
Take the Middles -- a middle-aged, middle-class married
California household with two children. Both spouses are
40. The kids are 7 and 10. Mr. Middle earns $75,000 per
year. Mrs. Middle earns $50,000. The couple has $75,000
in regular assets and owns a $300,000 home with a $125,000
20-year mortgage, with monthly payments of $1,250. Pro-
perty taxes, homeowner's insurance and maintenance total
$6,000 per year. The couple plans to spend $25,000 in
today's dollars on college tuition and other expenses for
each child for four years. Each spouse will retire at age
65 and begin collecting Social Security benefits in that
year. Both spouses experienced 4 percent wage growth since
they started work at age 22. The couple expects inflation
to run at 3 percent annually and to earn a 6 percent nom-
inal rate of return on savings.
According to ESPlanner (Kotlikoff's commercially available
financial planning program), Mr. Middle needs $485,000 in
coverage and Mrs. Middle needs $129,000 to smooth their
consumption. This will ensure survivors with the same li-
ving standard, assuming they live to age 95.
In contrast, using an 80 percent lost-earnings replace-
ment rate assumption, TIAA-CREF's Simple Calculator tells
Mr. and Mrs. Middle to buy a whopping $1.825 million and
$1.325 million in life insurance, respectively. The De-
tailed Calculator tells them to buy a bit less. Mr. Middle
is to buy $1.054 million in life insurance, and Mrs. Middle
is to buy $777,790.
Either way, the amount of insurance recommended is a
multiple of the amount recommended by consumption smooth-
ing. If the couple were to follow TIAA-CREF's Detailed
Calculator's recommendations, they'd pay close to $3,000
in premiums, or 2.3 percent of their combined annual
earnings. If the couple follow the Simple Calculator's
advice, they'll spend over $5,000, or 4 percent of their
earnings. This is a lot of money to pay for insurance
they don't need.
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If you're beginning to think that TIAA-CREF is some kind
of villain, don't. It is simply following common industry
practice. While there are a multitude of life insurance
calculators in use, virtually all share a common trait:
They systematically inflate life insurance needs because
of the calculation methods they use.
We point to TIAA-CREF because it provides two calculators,
not one. There aren't two answers to the question of how
much life insurance a household needs. So if TIAA-CREF
believes that $1.825 million is the right life insurance
holdings for the husband in our stylized household, why
does it offer its Detailed Calculator, which tells Mr.
Middle to dramatically underinsure by purchasing only
$1.054 million in life insurance? Alternatively, if TIAA-
CREF believes that $1.054 million is the right coverage
for Mr. Middle, why does it provide the Simple Calculator,
which will lead him to dramatically overinsure?
We think there is a clear answer: Marketing.
As with most financial institutions, the primary goal is
selling policies. Whether the amount of insurance is app-
ropriate is secondary.
TIAA-CREF senior vice president Bret Benham, when called
for comment, said: "Our site clearly states that the
simple life insurance calculator is intended to provide
customers with a rough approximation of the amount of life
insurance needed if death occurred today, but we recognize
that the actual amount required to help meet dependents'
needs may be higher or lower than the amounts shown."
An $800,000 difference, on its own calculators, is a
pretty good demonstration of "rough."
Next: Part 4, Soliciting Risk
ON THE WEB
Laurence J. Kotlikoff's Web page:
http://people.bu.edu/kotlikoff
ESPlanner software Web page:
www.esplanner.com
"The Coming Generational Storm"(at MIT Press):
http://mitpress.mit.edu/catalog/item/default.asp
"The Coming Generational Storm" (at Amazon.com):
www.amazon.com/gp/product/0262112868/002-5379885-1560022
Full comment from Bret Benham, senior vice president for
Individual Protection Products, TIAA-CREF:
"As Dr. Kotlikoff has said regarding his own insurance
calculator, they are simply tools to help find a solution.
Web-based calculators are not designed to replace a com-
prehensive evaluation of an individual's life insurance
needs. Many factors go into evaluating life insurance
needs, and the more information included in that assess-
ment, the more closely one can accurately determine the
level of coverage appropriate for their individual cir-
cumstances, goals and attitude toward investment risk.
"Our site clearly states that the simple life insurance
calculator is intended to provide customers with a rough
approximation of the amount of life insurance needed if
death occurred today, but we recognize that the actual
amount required to help meet dependents' needs may be
higher or lower than the amounts shown.
"We also clearly state that these calculators do not re-
flect the effects of inflation, taxes or the time value
of money. For a more detailed analysis we recommend that
customers contact our planning consultants, whose compen-
sation is not tied to commission sales, for a more detail-
ed assessment of their individual life insurance needs,
which could include factors like a spouse's income or
Social Security benefits."
(Questions about personal finance and investments may be
sent to Scott Burns, The Dallas Morning News, P.O. Box
655237, Dallas, TX 75265; or by fax: (214) 977-8776; or
by e-mail: scott@scottburns.com.
Check the Web site: www.scottburns.com.
Questions of general interest will be answered in
future columns.)
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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END OF INVESTOR'S INSIGHT
Copyright 2006 by NextEra Media. All rights reserved.
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