For the past decade, we have advised that there is a better, more client-centric, method of financial planning than the one traditionally embraced by advisors. In a moment, I will talk about two new developments in our approach. First, a brief review for newer readers.
For years planners have asked their clients about their goals and then calculated how much must be saved each and every year to fund each goal. The client is encouraged to dream big. In this method, how to reach “the number” almost always involved recommendations to save more, spend less. This kind of planning, while widely accepted, is often in the advisor’s interest over that of the client.
We believe that a more client-centric method is based on a century-old economic theory: consumption smoothing. Consumption, i.e. spending, is what determines one’s living standard. The basic premise of consumption smoothing is that we consumers prefer a smooth, growing standard of living to one that is disrupted when we retire or send our children to an expensive college. Of course, we will gladly accept upside disruption caused by a windfall. It is the downside disruption that concerns most of us and remains the focus of our analysis.
Up until a few years ago, it was nearly impossible to figure out a smoothed living standard, adjusted for inflation, over the course of one’s lifetime. Around the turn of this century, modern and affordable computers in the hands of competent planners ushered in post-modern financial planning. The developer was Boston University’s Laurence J. Kotlikoff. If you haven’t read it, I highly recommend his book, Spend ‘til the End. His three commandments of economics are: maximize your spending power; smooth your living standard; and price your passions.
Consumption smoothing enables us to put a valid price on alternative choices: taking more call, buying a different house, changing jobs, choosing which college Junior will attend, working more or fewer years, choosing a start date for social security, etc. Using our modern tools, the effect of any current or future decision can be measured and illustrated on its impact to living standard, over a lifetime, adjusted for inflation.
The newer developments in the technology now offer even greater potential benefit to our clients using this method of financial planning. The first of these, Monte Carlo simulation, has been used for years to simulate stock market returns. Because market returns are probabilistic and not deterministic, Monte Carlo can be used to determine the impact of different investment portfolios on future outcomes. Kotlikoff claims that his program is the only one available today that uses Monte Carlo to determine the impact on living standard, after taking into consideration social security and/or pensions.
The second development has to do with the evolution of our own thought process and builds on the consumption smoothing approach. Historically, in a strictly utilitarian manner, economists have simply measured rising living standard by the growth rate of the economy. More economic output in the aggregate equals higher standards of living and vice-versa.
With thanks to our economist Dr. Woody Brock, we have become convinced that there is a more correct way to measure changes in living standards. The theory is called Revealed Preference and was introduced by Paul Samuelson of MIT about 70 years ago. Using our modern tools and that theory, we can index living standard and make desired adjustments today that affect a client’s future. Doing so enables us to look for quantifiable ways to improve living standard, without regard to the published economic data.
Scott Neal is president of D. Scott Neal, Inc. a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Call 1-800-344-9098 or email to email@example.com.