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        Investor's Insight - Wednesday, April 26, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


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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, written by Laurence J. 
Kotlikoff and me, explores the consumption smoothing app-
roach 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 

In recent columns we've criticized conventional financial 
planning. We said it engaged in target practice, promoted 
consumption disruption, solicited risk, provided quick but 
erroneous "solutions," and made outrageously bad saving 
and insurance recommendations. In short, we've suggested 
that advice givers, particularly large marketing-driven 
financial institutions, are engaging in financial mal-

The Oxford Dictionary defines malpractice as "improper, 
illegal or negligent professional activity or treatment." 
We don't suggest there is anything illegal about the ad-
vice being dispensed. We do believe it is improper and 



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When it comes to providing financial advice, everyone 
from the neighborhood financial planner to TIAA-CREF 
has a fiduciary obligation to provide the appropriate 
"standard of care." Economists have spent a century 
defining and refining the proper standard of care when 
it comes to financial advice. But the actuaries, who 
have developed conventional planning tools, have yet to 
make contact with consumption smoothing -- the core 
principal underlying the economic theory of saving, 
insurance and diversification. 

Much of the blame here lies with economists. They've ig-
nored the bad advice being delivered, preferring the com-
fort of their research work. Imagine MDs doing nothing 
but research, never leaving their laboratories. The pub-
lic would be forced to turn to untrained medicine men 
for their health care.

Economists are now in a position to prescribe financial 
behavior, not just describe it. In particular, they are 
in a position to apply dynamic programming, an advanced 
mathematical technique that is essential for smoothing a 
household's living standard without putting it into debt. 
Unfortunately, dynamic programming is not something act-
uaries learn in school. 

To see the need for dynamic programming, take Dan and 
Elaine Grunberg -- a middle-age household that has sign-
ificant "off-the-top"expenditures, including mortgage 
payments, college tuition and 401(k) contributions. Since 
the Grunbergs can't borrow against their future 401(k) 
withdrawals, they are forced to accept a lower living 
standard before retirement. 

Let's make this concrete. Dan and Elaine are 35, make 
$50,000 each, have two kids, ages 10 and 13, a $300,000 
house with a 20-year $2,000-per-month mortgage, a $3,000 
annual property tax bill, and $3,000 in other yearly 
housing expenses. Each spouse has $100,000 in a 401(k) 
and makes annual contributions of 5 percent of his/her 
salary, which triggers an equal employer match. The Grun-
bergs plan to spend $30,000 per child per year for four 
years of college. Finally, the Grunbergs have $50,000 in 
regular assets, plan to stop contributing to and start 
withdrawing from their 401(k) at 59, and plan to retire 
at 62. 

According to ESPlanner (Kotlikoff's company's software), 
which uses dynamic programming, the household's living 
standard (per equivalent adult) is $26,241 prior to gett-
ing the kids through college (age 58) and $31,333 there-

Does this mean consumption smoothing isn't important for 
the Grunbergs? On the contrary, it's even more important. 
The Grunbergs face not one but two consumption smoothing 
problems. They need to smooth their living standard prior 
to age 58, and after age 58. And they need to ensure that 
the rise in their living standard at 58 -- their consump-
tion disruption -- is as small as possible.

To smooth their initial living standard, the couple need 
to accumulate $101,985 prior to the oldest child starting 
college. Over the next seven years, the Grunbergs spend 
down this wealth on college tuition and on their own liv-
ing standard. Only when they make their last tuition pay-
ment at age 57 can they finally start saving for retire-
ment, which they reach with $114,713 in new savings. These 
assets, together with Social Security benefits and 401(k) 
withdrawals, support their higher living standard in re-

Dynamic programming works by making general plans, starting 
with the household's last year of life and working backward 
to the present. The plan for the next to the last year of 
life is based on the plan for the last year. The plan for 
two years before the end is based on the plan for the next 
to the last year, etc. 


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This technique turns out to be critical for figuring out 
the intervals during which the Grunbergs are constrained 
from borrowing as well as determining how much needs to 
be saved during each interval. Dynamic programming is also 
needed to evaluate the advantage of additional retirement 
account contributions. 

Cash-constrained households -- and few aren't -- face a 
tradeoff from extra contributions, namely a lower living 
standard now but a higher one later. In the Grunbergs' 
case, contributing an extra $1,000 each to their 401(k) 
plans lowers their annual living standard before age 57 
by 2.6 percent and raises it thereafter by 4.5 percent. 
This is an eight-second calculation with the right dynamic 
program, but an impossible calculation without it. 

So what's our bottom line as we conclude this series on 
financial advice and consumption smoothing? It's an appeal 
to advice givers to either do it right, or get out of the 
business. It's also a warning to the public that most pro-
fessional advice is not worth the taking.


Wikipedia on "dynamic programming": 

(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 

(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).



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