Thursday, August 16, 2012

ESPlanner

I'm back from a brief trip to the Boston area, where I spent a couple of days at the Retirement Management Analyst (RMA) intensive seminar at Salem State University. The Salem/Marblehead area is a beautiful part of the country and full of colonial history. And the seminar participants were all very interesting and came from a diverse set of backgrounds in the financial services world.

On Tuesday, I was presenting at the seminar for most of the day (I think I was talking for about 5 hours in total, using a presentation that I can get through in one hour when pressed, as there was lots of good accompanying questions and discussions), but I also enjoyed the explanation by one of the participants about software used in practice which follows Moshe Milevsky's product allocation approach.

On Wednesday, the special event was the visit by Laurence Kotlikoff, who presented about his ESPlanner software for lifetime financial planning. I actually became a paying customer for that software back in 2007, but then had gradually gravitated toward a spreadsheet I had made for my own household's lifetime financial planning. Nonetheless, it was interesting to hear Prof. Kotlikoff's explanations about how the software was constructed, which gave me a better understanding and made me interested to have another look at the software, if only to confirm that I get the same general results as with my own spreadsheet.

ESPlanner is based on underlying principles of academic economics. It is based on lifecycle finance, which involves maximization of lifetime expected utility. However, very cleverly, Kotlikoff built the software to simplify a few steps away from formal utility maximization. That is because using a formal utility function involves the unrealistic expectation that we can define such variables as a person's risk aversion coefficient, minimal consumption floor, a factor for how they view the tradeoff between spending today and spending tomorrow, and so on. What Kotlikoff does instead is allow users to specify whether they wish to make spending plans based on the assumption that they will earn the expected return from their investment portfolio, half of the expected return, a real return of zero, or an upside approach which assumes that the value of all stock holdings will go to zero, but will then add upside spending later as stocks are converted to TIPS. That last one was inspired from talking with Zvi Bodie. This is an alternative way of allowing users to estimate their own attitudes toward risk.

And we must be clear about what risk means in ESPlanner. As ESPlanner is based on the economics approach to lifetime financial planning, what people want to do is to smooth their lifetime consumption (basically, enjoy the same living standard for each member of the household for each year of life through a maximum planning age). People want to smooth their consumption and to get that smoothed consumption level as high of as possible. And so the risk is risk to one's lifestyle. That is the risk that events will take place which force consumption to decline from the currently determined level.

Lifecycle finance manages this risk by shifting consumption from good states of the world to bad states of the world. In technical terms, consumption is shifted from low marginal utility states to high marginal utility states. In other words, when things are working out well you feel more satiated and will be happier on an ex ante basis by shifting some of that consumption to the bad luck cases when consumption is low. That is when a bit more consumption would be gladly welcomed.

Risks to lifestyle are managed through precautionary savings (save more than needed in case you lose your job or experience bad market returns), diversification (by diversifying between stocks and bonds you lose some upside when stocks go up but avoid some downside when stocks go down), insurance (decrease consumption by spending on insurance premiums in good states of the world which pay off with protections in bad states of the world), and hedging (find strategies where bad outcomes are offset with a good outcome from the hedge and vice versa).

Though the point is quite obvious, there is something Prof. Kotlikoff said that resonated with me as being a really important way of stating the matter. That is, risks to lifestyle depend not just on investment decisions, but also on spending decisions. The more aggressively one spends, the greater the risk to future lifestyle. I'm still thinking through whether aggressiveness in spending will also be linked with aggressiveness in investing, or whether a person can rationally be more aggressive in one aspect but less aggressive in the other. Perhaps these are two sides of the same coin. As I think about it, I believe this was one of the results we determined in the "spending flexibility" article with Michael Finke and Duncan Williams. I need to read that again in light of what Larry Kotlikoff said.

Do note as well that an important point about consumption smoothing is that it tends to throw out the window the traditional notion that people should aim to replace 80% of their gross salary in retirement. That is a rule of thumb that will only be optimal (even approximately) by coincidence. Replacement rates should properly be based on what smoothes one's living standard over time, both before and after retirement. This basic rule of thumb could cause some people to over save and defer too much pre-retirement consumption, and it could cause others with a large amount of financial assets relative to income to spend much less than necessary in retirement.

The software is very interesting. When I used it 5 years ago, I guess I gravitated toward my own spreadsheet because ESPlanner only considers one scenario at a time, and to compare different strategies (different asset allocations, investing in different types of tax-sheltered vehicles, etc.), it required re-running scenarios after changing various assumptions. It would also require re-running things to consider changing assumptions such as the ratio of spending needs of children compared to adults (one might play with assumptions such as that children only spend 70% as much as an adults) or how much more spending is needed to support two adults living together, compared to one. That is also true with my spreadsheet, but because I do not need many of the assumption screens built into the software for my more basic personal situation, it was easier to keep track and change assumptions in a more basic spreadsheet in which I smooth consumption manually rather than with dynamic optimization routines which Kotklikoff developed. The basic idea of what I aim to do in my own planning spreadsheet does match the underlying approach I learned from ESPlanner. At any rate, I am eager to have another look at the software. A relatively sophisticated free basic version is available at his website.