04/02/2006Financial Planning 1.0 -- what most of us encounter through advisers or on the Internet -- meet version 2.0. This eight-part series of columns, written by Laurence J. Kotlikoff and me, explores the consumption 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.
Economists have a hard time making up their minds. President Truman asked for a one-handed economist so he could stop hearing the phrase "on the other hand." But economists are sure of one thing -- the need to do proper financial planning.
Unfortunately, two-thirds of all Americans never attempt to formulate a financial plan. Of those who do, two-fifths end up ignoring them. Perhaps we're relying on our employers and Uncle Sam to fund our retirements. If so, it's time for a reality check. Corporate America is busy abandoning its pension commitments. Its message, conveyed most recently by IBM's pension plan termination, is clear: "Workers, you're on your own."
Uncle Sam, for his part, is going broke. He's currently handing retirees more than $30,000 per head in Social Security, Medicare and Medicaid benefits each year. Worse, the number of people collecting those benefits is about to surge as 76 million baby boomers claim even higher levels of support. The collective price tag is far beyond Sam's ability to tax or pay.
So baby boomers can expect a nasty combination of tax hikes and benefit cuts in retirement. These cuts will come on top of those already under way. Yes, already under way. We refer to the rise in Social Security's normal retirement age, the expansion of Social Security benefit taxation and the increase in Medicare premiums. For most boomers, these three adjustments equate to a roughly 25 percent cut in future Social Security benefits.
Were boomers saving much on their own, this might not be a problem. But most boomers are saving far less than what's needed to maintain their lifestyles -- even with no tax hikes or benefit cuts. They're good kids, following the example set by their parents, two-thirds of whom are largely dependent on Social Security.
Depressed yet? Well, we believe the "dismal science" can prescribe solutions as well as describe problems. Indeed, we believe it's time for economists to shift from studying financial pathology to writing financial prescriptions.
Economics' main prescription for financial health is "consumption smoothing," which means achieving and maintaining one's highest living standard. Consumption smoothing underlies everything economists have to say about saving, insuring and investing.
Until now, economists have had no practical way to convey consumption smoothing to the public. So they've stuck to their research. They let financial planners and investment companies dispense financial advice. Imagine doctors locking themselves in their labs and letting unlicensed practitioners and tonic vendors determine our ailments and medications.
Financial quackery, like medical quackery, is dangerous. Determining how much households need to spend, save, insure and diversify to smooth their living standards is incredibly complicated. The short list of interconnected factors includes household demographics, earnings, taxes, housing plans, economies of shared living, the relative costs of children, medical costs, retirement accounts, mortgages, special expenditures, pensions, Social Security benefits and estate plans.
Conventional financial planning asks us to do this rocket science in our heads. Specifically, it asks us to set our own retirement and survivor spending targets. Guessing our target within even 10 percent of the sustainable level -- the level that provides the same living standard now and in the future -- is virtually impossible.
But even targeting mistakes of 10 percent, since they apply to all the potential years of retirement and survivorship, can lead to huge mistakes in saving and insurance recommendations. They can also lead to major disruptions (on the order of 30 percent) in our living standards when we retire or become widowed.
The worst offenders when it comes to financial guessing are the large investment companies. Their interest is not financial planning, but sales. That's why their Web calculators suggest very high saving targets and offer "simple" and "quick" answers. The goal is to move us quickly from planning to purchasing.
There is a better way. It's called consumption smoothing. It can now be done on virtually any personal computer. And the first generation of software, developed by Laurence Kotlikoff, now exists. Financial planning will never beat sex. But being able to raise your living standard in a matter of seconds is pretty darn sexy.
(Tuesday: Part 2, The Wrong Number)
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(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: email@example.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.)