Paula Hogan’s article in the June 2012 Journal of Financial Planning is Financial
Planning: A Look from the Outside In. It picks up where she left off five
years ago with her May 2007 JFP
article, Life-Cycle
Investing is Rolling Our Way. An objective of both articles is to try to
convince the financial planning community to pay closer attention to the theory
of life-cycle saving and investing connected most closely with economists Paul
Samuelson and Robert Merton, and later with Zvi Bodie as well. She admonishes
the CFP Board for not including life-cycle finance in the CFP curriculum.
As a side note, I am curriculum director
for the Retirement Management Analyst designation, which is very focused on
building practical applications from life-cycle finance concepts. I will be one
of the speakers, joining luminaries including Zvi Bodie and Laurence Kotlikoff,
at the Salem State University boot camp for the RMA in August, and more
information about that is available at the end of this post.
Hogan’s contribution in this new article is
to synthesize key concepts from the lifecycle finance theory of academic economics
with the financial planning movement called “life planning.”
Briefly, life planning is “the process that
facilitates the discovery and achievement of one’s lifetime goals.” As it
involves elements of psychology and counseling, discussing it in detail is a
bit out of my element. Hogan’s argument is that lifecycle finance provides a
rigorous theory to justify the concepts of life planning, and that the role of financial
planners must increasingly be to facilitate clients with a “lifelong process of
integrating personal values with the management of both human and financial
capital for the betterment of self and community.”
I think that the key to integrating the two
concepts is that both make human capital
as a centrally important focus. Human capital is the present value of your
lifetime earnings. This is a central point, because it suggests that financial
planners should worry much more about getting clients on the career path
which best meets all of their goals related to satisfying work, life-leisure
balance, high salary, recharging one’s batteries in order to be more productive
overall, the ability to do things that provide value and meaning to life, etc.
It is about managing human capital. This
includes having proper disability and life insurance and also something called
“career asset management” which I think focuses on strategies to build ones
career and to also have contingency plans for changing careers should the need
arise. Investing in education, training, and so forth, should be evaluated in a
comprehensive manner in terms of lifetime monetary and psychic costs and
benefits.
As such, managing the investment portfolio
is only of secondary importance. And portfolio management must be done in a way
that complements human capital (this is the normal lesson of figuring out
whether your human capital is a stock or a bond and then reacting accordingly).
Secondly, people care most about their life-time standard of living, not
portfolio wealth. I agree wholeheartedly with this. It’s been a common
theme here. Are there really still financial planners who focus solely on “The
Number”? They should stop doing that. For one thing, the number varies with
interest rates. For another, it varies with market valuation levels. Wealth is
also abstract in the sense that what looks like a lot of wealth may be much
less impressive when you start to think about the annual spending power it can
potentially support.
In order to shift the focus to lifetime living
standards, life-cycle finance focuses on smoothing consumption, which consists
of shifting consumption from times of plenty to times of scarcity. This
includes saving for retirement, purchasing appropriate insurance, building
downside protection and protecting against longevity and inflation risk.
Life-cycle finance also focuses on matching
investments to goals. Risk capacity becomes more important than risk tolerance.
This means, when working to meet essential goals for which failure would be
catastrophic, you have little room to take risks (defined as accepting greater
volatility in an attempt to obtain higher returns) and should focus on matching
safe investments (such as TIPS) to the goals. It doesn’t matter if you feel
like an aggressive investor. Relying on high stock market returns is a hope,
not a plan. Your aggressiveness should only manifest after you have the basics
covered and are then working to meet more discretionary goals.
I’m not sure if I still fully accept all of
the last paragraph myself. I think this may be a natural dividing point where
people may have fundamental disagreements. The alternative to the above is to
use a well-diversified portfolio and to focus on the probabilities of meeting
goals. Since using safe investments is quite expensive in the current low
interest rate environment, a more diversified portfolio may give a higher
probability of helping one to reach one’s desired lifestyle, even though it
will also increase the probability that the basic needs are not met. But people
with enough flexibility may be willing to take their chances on this. Though he
was talking about something different at the time, I think a quote from Harold
Evensky applies here: “Advising clients to radically reduce their standard of
living in order to protect against the unlikely probability of three standard
deviation events is inappropriate.”
More generally, there are other approaches
to flooring besides the goals-based approach which Hogan describes. My most
recent Advisor Perspectives column provided an attempt to clarify some of these
differences which came about in discussions with the RMA Curriculum Advisory
Board. Of course, I must include, the alternative versions of flooring do
assume that you have sufficient assets to build a floor which meets basic
needs, and Hogan is specifically discussing the case where you are underfunded
with your attempts to meet basic goals. That does complicate things.
Unfortunately, this underfunding case describes all together too many Americans
now approaching retirement. Should these folks use what they have to buy an
inflation-adjusted immediate annuity, or should they take their chances with a
diversified portfolio? There is no generalized agreement on the answer to this
question.
One more point which Hogan makes, and which
I think Zvi Bodie has been making for at least 10 years, is that we are on the
cusp of a new era of retail financial products based on derivatives, which will
allow for dividing up more risks and spreading them to who is best equipped to bear
them. Dealing with financial derivatives is now rather standard for
corporations, but it is still rather limited for households. It seems that this
retail revolution has been slower coming than expected, but that doesn’t mean
it won’t still happen.
+ + +
+ + +
+ +
Add
Sizzle to your Retirement Income Business by Earning the Retirement Management
Analyst Designation this Summer!
Coming
in August is the Salem State University Intensive Seminar to prepare for the
Retirement Management Analyst (RMA) Designation.
Summer
is a perfect time to earn this advanced education and heat up your retirement income
business by attending this 5-day in-class intensive seminar from Monday through
Friday, August 13-17, 2012.
The
seminar costs just $1,575 including refreshments and lunch. On campus lodging
is available for a low additional fee. To sign up for the summer seminar,
contact Salem State University, Professional and Community Enrichment Programs
or go to www.salemstate.edu/noncredit.
Key
faculty and guest instructors include:
- Francois Gadenne, Chairman and Executive Director, Retirement Income Industry Association
- Stephen Mitchell, Director, Advisor Education, Retirement Income Industry Association
- Dana Anspach, CFP®, RMA, Founder, Sensible Money, LLC and the www.About.com Guide to MoneyOver55
- Zvi Bodie, the Norman and Adele Barron Professor of Management, Boston University.
- Lawrence Kotlikoff, PhD, Professor of Economics, Boston University
- Dan McGrath, Director of Healthcare Funding Strategies, at HVS Financial
- Alain Valles, Founder and President, Direct Finance Corporation
- Wade Pfau, Associate Professor at GRIPS and Curriculum Director for the RMA Designation
