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        Investor's Insight - Monday, April 17, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


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 
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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 

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-

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-
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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.


Previous columns

Laurence J. Kotlikoff's Web page: 

ESPlanner software Web page: 

"The Coming Generational Storm" (at MIT Press): 

"The Coming Generational Storm"(at Amazon.com): 

(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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