Is Conventional Financial Planning Good for Your Financial Health?

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Research Foundation Publications
February 2008 | Vol. 2008 | No. 1 | 17 pages
Source: CFA Institute
Laurence J. Kotlikoff

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Summary

Economics teaches that households save, insure, and diversify in order to mitigate fluctuations in their living standards over time and across contingencies (i.e., practice consumption smoothing). But for households, setting spending targets that are consistent with consumption smoothing is incredibly difficult, and even small targeting mistakes (on the order of 10 percent) can lead to enormous mistakes in recommended saving and insurance levels and to major disruptions (on the order of 30 percent) in living standards in retirement or widow(er)hood. Conventional planning’s use of spending targets also distorts its portfolio advice because the standard Monte Carlo simulations assume that households make no adjustment whatsoever to their spending regardless of how well or how poorly they do on their investments. But consumption smoothing dictates such adjustments and, indeed, precludes running out of money (i.e., ending up with literally zero consumption). It is precisely the range of these adjustments that households need to understand to assess their portfolio risk.

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