Publication: Investor's Notebook
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Investor's Insight - Monday, April 17, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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FINANCIAL PLANNING 2.0, PART 5:
FREE MONEY, NO HEAVY LIFTING
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, writ-
ten by Laurence J. Kotlikoff and me, explores the con-
sumption smoothing approach to lifetime personal finance.
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 security.
Do you have recurrent idle thoughts, such as, "If I had
a million dollars, I would ..." or "If I could just in-
crease what I can spend by ..."
We do too.
But we think there is something better to do than sit
around waiting for money to appear. We can do some fin-
ancial planning. Do it, and we may be able to raise our
standard of living without breaking a sweat.
The question is what are the moves that work? And what
moves don't?
Think about some of the questions we face. This job has
a high starting salary, but low earnings growth. That
one has the opposite. This mortgage has low payments now,
high ones later. That mortgage has fixed payments. Con-
tributing to an IRA lowers current taxes, but raises them
down the pike. Taking Social Security early means receiv-
ing lower benefits, but for more years ...
Worse, all these decisions are interconnected. Change one
thing, and you change another. Take IRA contributions.
The more you put in, the more you can take out. But your
withdrawals are "taxable income." Take enough, and you'll
have to pay income taxes on your Social Security benefits.
If you contribute to a Roth IRA, you'll pay more taxes
now but avoid taxation later.
The timing and amounts of your IRA contributions and
withdrawals interact with the timing and level of your
Social Security benefits. That determines how much of
your Social Security goes back to Washington.
So how do we figure out what's best?
The answer comes from economics. Combined with high-
powered math and modern computers, it can determine how
these and other decisions affect your sustainable living
standard, using an idea called consumption smoothing.
Rather than focus on a single economic project -- like
buying a first or second home, paying tuition at Stanford
or retiring early, projects that will affect everything
else in your life -- consumption smoothing synthesizes
every major life decision and evaluates its impact on
your lifetime standard of living. Because it solves the
complicated math problem of providing the same standard
of living throughout your life, consumption smoothing
never borrows from Peter to pay Paul. And it never re-
duces today to increase tomorrow.
Once you've plugged in your special spending goals and
housing plans, consumption smoothing software (such as
ESPlanner, marketed by Kotlikoff's company) will deter-
mine how much to spend each year to achieve a smooth
living standard. You can also use such software to find
ways to maximize your living standard. This type of ana-
lysis has the potential to revolutionize financial
planning. It's at least as significant an advance as the
introduction of probabilistic Monte Carlo modeling that
financial planners now proudly display to clients.
Want some proof?
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Here's what consumption smoothing can do for a hypothe-
tical couple, Jessie and Josie Jay. The Jays are 40,
married, live in Wisconsin, make $40,000 each and have
a 6-year-old named Jenny and a 10-year-old named Jamie.
The Jays also have $150,000 in regular assets, a
$300,000 house, and a $150,000, 20-year mortgage with
a $1,000-per-month payment and other commensurate
housing expenses.
Jessie and Josie plan to pay college expenses for the
little Jays of $20,000 per year each (in today's dollars)
for four years. They also plan to retire and start coll-
ecting Social Security at age 62. Being conservative,
the couple invests only in TIPS -- Treasury Inflation
Protected Securities yielding 2 percent above inflation.
Consumption smoothing recommends the couple save $3,452
this year and consume (apart from housing expenses)
$45,214 until Jenny goes to college, $38,671 thereafter
until Jamie goes to college, and $31,551 once both kids
have left the nest. These numbers are all in today's
dollars.
Is that smooth and stable? You bet. In adjusting recom-
mended spending to the number of mouths to feed, con-
sumption smoothing takes into account economies in shar-
ed living and the relative cost of children. Two can't
live for the price of one. But two don't cost twice as
much as one, either. And there is a reason it's joked
that children are cheaper by the dozen.
Although total spending changes over time, consumption
smoothing delivers a stable $19,719 living standard per
adult. It does this year in and year out. (This is the
amount of spending Jessie or Josie would need as a
single person with no children to enjoy the same living
standard he/she enjoys in the household.)
That's nice, but can they do better? Yes.
Now suppose Jessie and Josie open up IRA accounts,
contribute $3,000 a year each through retirement to
these accounts, and withdraw their balances smoothly
starting at age 65. Doing so raises their living
standard to $20,197 -- a non-trivial increase.
The Jays can do even better -- achieve a $20,675 living
standard -- by withdrawing all of their IRA balances bet-
ween ages 62 and 67, and electing to start receiving
Social Security benefits at age 68. This allows the Jays
to limit taxation of their Social Security benefits,
which depend on the amount of taxable income, including
IRA withdrawals. It also lets the Jays take advantage
of the terrific increase in Social Security benefits
provided by Uncle Sam for waiting to start benefit coll-
ection.
Finally, if the Jays move to Texas, with its zero state
income tax, and maintain their same housing expenses,
they can get their living standard up to $21,690. This
is a 10 percent increase over the original $19,719!
It's not hitting the jackpot, but it's a huge improve-
ment, given that it costs them nothing to make these
decisions.
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This increase isn't for a single year. It is a benefit,
in real dollars, that they enjoy every year from the
start of their plan, age 40, until they die.
None of these results would be suggested by conventional
financial planning. It would suggest a college savings
project that would crush their current living standard.
It would suggest a separate retirement savings project
that would lower their standard of living while they
were working, and it would miss the impact of lifetime
changes in taxes.
Can anyone do these calculations in their head? No way.
But a good laptop with consumption smoothing software
can spin such results out in seconds and also provide
Monte Carlo simulations that show not just the expected
level of your living standard, but its potential varia-
tion as you age.
ON THE WEB
Previous columns
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
(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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