Planning A Smooth Financial Ride

Economists offer their own brand of advice

Financial planning can be awfully ad hoc. You start out with your dream--say, enough money to put three kids through Yale and retire to a ranch in New Mexico. Then you gradually whittle back until you come up with something that you can realistically save for without having to live on thin gruel and day-old bread. Software speeds up the search for plans that can keep you solvent. But most programs--and most flesh-and-blood financial planners, for that matter--have a hard time saying whether any given plan is the best possible one for you.

The problem is that there is no standard for what's "best" in financial planning. So the responsibility of choosing a plan falls on the client, who is swimming in uncertainty. Wouldn't it be nice if there were some kind of rule to go by?

Economists think they have one. It's known as life-cycle smoothing. It aims to determine the highest possible standard of living that you will be able to maintain for the rest of your life. If you live too well today and save too little, your living standard will have to drop in the future. That's bad. On the other hand, if you deprive yourself too much now, then either you'll leave your kids richer than you intended or you'll spend like crazy in your old age. That's not ideal, either. The reason for trying to keep your standard of living as steady as possible throughout your life, according to economists, is that really good times never quite make up for really bad times. Smoother is better.

MORTGAGE FALLBACK. That simple idea has powerful consequences. First, it emphasizes that saving is not an end in itself; spending is. Saving is good only insofar as it helps you to even out your living standard over a lifetime. For instance, it doesn't make sense to starve yourself when young for the future benefit of your old and rich self. Life-cycle smoothers are also skeptical of the financial planners' motto that you should "pay yourself first," by giving top priority to savings goals. The problem is that by locking in savings targets, spending becomes the swing factor, rising and falling erratically as income and expenses vary. To economists, spending is the main event, not an afterthought.

Three economists--Laurence Kotlikoff of Boston University, Douglas Bernheim of Stanford University, and Jagadeesh Gokhale of Solon, Ohio--have incorporated these concepts in a new software package called Economic Security Planner, which is available at their Web site, In commercial terms, the $49.95 ESPlanner is a mite. Only about 70 copies have been sold. But its approach to financial planning profoundly challenges well-known programs such as Intuit Quicken Deluxe 2000. The differences are illuminating, even for people who will never touch a planning program.

ESPlanner starts with the idea that you want to die broke, except for money you've set aside for bequests, an emergency fund, and, in most cases, the equity in your house. To guard against outliving your assets, it advises you to set your expected age of death high--the default is 95--and to keep your house debt-free so that you can mortgage it if you survive longer.

Then comes the plan. Using your typed-in financial vital statistics, ESPlanner produces the annual levels of consumption and savings that give you the smoothest possible lifetime standard of living. This is no small bit of math: Even a high-powered personal computer takes about 45 seconds to spit out a plan for a married couple. For many households, their living standard will still come out lower when they're young than when they're old, which is less than ideal under the smoothing theory. This is usually because most people face a "borrowing constraint," limiting how much they can borrow against future income to raise their present standard of living.

Economists are acutely aware of the difference between a household's consumption and its standard of living: As children are born, for instance, it takes more spending to maintain the same standard of living. Most planning programs don't prompt users to raise and lower their consumption as their household grows and shrinks.

ESPlanner does. Its formula generates the correct level of consumption for each period--something that takes hours and hours of diddling in other programs.

THE STORK FACTOR. ESPlanner and Quicken can produce quite different results. Kotlikoff, Gokhale, and Mark Warshawsky, research director of the TIAA-CREF Institute, laid them out in a working paper published in August by the National Bureau of Economic Research and available on its Web site, (Their comparison was with Quicken Financial Planner, a program that has since been rolled into Quicken Deluxe 2000.) In one scenario, "Jane" and husband "George" have one child in 1997 and another in 2001. Quicken doesn't automatically adjust spending for the size of the household. ESPlanner has a spending rise when the children are born, then has it drop back when the kids leave home. That leaves less money for savings in the early years: ESPlanner recommends just $3,000 in annual savings at first, opposed to $7,300 as recommended by Quicken.

Executives at Intuit are probably not ecstatic over having their best-selling Quicken program compared with one that has sold 70 copies. Daniel Olsen, lead product manager for Quicken for Windows, said that he had not heard of life-cycle smoothing and asked: "Is the average American going to understand these high-powered concepts?"

Quicken is trying to make matters simpler and no longer offers Quicken Financial Planner as a stand-alone program. "The product was really popular with do-it-yourselfers. But most people don't plan that way. You had to pour in lots of data before you got anything useful," says Olsen. Instead, Quicken 2000 has a financial-planning feature designed to allow people to budget for particular goals, such as college or retirement, without having to put together a comprehensive plan.

HOG FOR DATA. To Kotlikoff, though, setting savings targets in the absence of an overall plan is "going even further in the wrong direction." When they're not dinking around with financial-planning software, Kotlikoff says, people intuitively follow life-cycle smoothing precepts. They save less when money is tight. And if they get a windfall, they typically save most of it.

ESPlanner is not likely to take the world by storm. It is somewhat dense and requires lots of data. Fellow academics, however, have rallied to it. The Web site features endorsements from two top economists at Massachusetts Institute of Technology: Stephen Ross and Nobel laureate Franco Modigliani. Ross even goes so far as to say that "those who fail to use it do so at their peril."

Most financial-planning software is scrupulously neutral about the choices that users make. The programs simply take what they're given and project the expected consequences of a particular option. Kotlikoff and company have stronger opinions about what's right and wrong. What's right, by their lights, is life-cycle smoothing. Through efforts such as theirs, a concept that economists have embraced for years may finally start penetrating the world of financial planning.

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