Economics' Approach to Financial Planning

Kotlikoff, Laurence J.
March 2008
Journal of Financial Planning;Mar2008, Vol. 21 Issue 3, p42
Academic Journal
• Economists long have shown that when it comes to consuming lifetime economic resources, households seek to neither splurge nor hoard, but rather to achieve a smooth living standard over time. Consumption smoothing not only underlies the economics approach to spending and saving, it is central to the field's analysis of insurance decisions and portfolio choice. • Smoothing a household's living standard requires using a sophisticated mathematical technique called dynamic programming to solve a number of difficult and interconnected problems. Advances in dynamic programming coupled with today's computers are permitting economists to move from describing financial problems to prescribing financial solutions. • Conventional planning's targeted liability approach has some surface similarities to consumption smoothing. But the method used to find retirement- and survivor-spending targets is virtually guaranteed to disrupt, rather than smooth, a household's living standard as it ages. Moreover, even very small targeting mistakes will suffice to produce major consumption disruption for the simple reason that the wrong targets are being set for all years of retirement and potential survivorship. • But with this economics approach, planners can not only smooth their clients' living standards, but also raise them. For example, they can determine precisely by how much living standards will rise if their clients wait to take Social Security, contribute more to a retirement account, choose job A over job B, or invest in more education—or how much their living standards will decline if they retire early, have another child, buy a cabin cruiser, or make regular gifts to their kids. • Finally, the economics-based living standard risk/reward diagram will replace the conventional mean-variance diagram as the standard framework for seeing the potential pain and pleasure from risky investing. In focusing on what can happen to a house-hold's living standard as opposed to what can happen simply to its financial assets, the new diagram incorporates the risk of other economic resources such as labor earnings and Social Security benefits.


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