The financial industry seems to produce a shiny new planning tool every few months. New Retirement is one of the latest variants. It differs from other conventional planning tools by doing both conventional and deterministic planning. Conventional planning treats investment returns as random. Deterministic planning treats them as fixed.
This article compares New Retirement with MaxiFi Planner, which delivers economics-based financial planning. MaxiFi Planner is my company’s software. Hence, I’m not a disinterested reviewer. Still, my views about New Retirement are those I believe any economics or finance professor would hold. And my comments mainly compare conventional planning with economics-based planning, not the two programs per se.
Conventional Financial Planning
Conventional planning begins by having users or clients set an annual retirement spending goal. The goal is typically set at 80% of your (your client’s) pre-retirement income. Alternatively, the retirement-spending target is based on your desires or your current spending.
An 80 percent replacement rate is generally far too high. As for our desires, they are the definition of unaffordable. Meeting them is why most working households are spending far too much. Thus, using current spending to target future spending extends financially dangerous behavior.
Once “your” target is set, conventional planning runs Monte Carlo simulations to determine if “your” plan is safe. Specifically, your initial wealth and annually pre-retirement saving are accumulated and your post-retirement targeted spending is decumulated based on randomly-drawn annual investment returns.
Your probability of plan success is measured as the share of these simulations that achieve positive terminal wealth. The industry views an 80 percent or higher plan-survival rate as successful/safe.
But having a one-in-five chance of running out of money in retirement doesn’t possibly meet a reasonable fiduciary standard! Yet, somehow, FINRA, the Financial Industry Regulatory Association, has blessed the use of conventional planning.
If, as is highly likely, you are saving too little, targeting your retirement spending too high, and investing conservatively, “your” plan will surely fail. I.e., you’ll run out of money more than 20 percent of the time.
Once your plan is pronounced a failure, conventional planning (but not responsible financial planners) doesn’t tell you to save more and spend less. Instead, you’re advised to invest in higher yielding (i.e., riskier) securities or the tools/websites running conventional planning programs connect you with an adviser to do so.
Yes, more aggressive investing raises the probability of plan success. But it also raises the generally undisclosed chance of running out of money earlier in retirement, i.e., spending more of your retirement in poverty. (And, yes, FINRA should be requiring disclosure of this and other risks from conventional planning. This includes making overly optimistic risky return assumptions.)
In sum, conventional planning reinforces two key financial problems – saving too little when young and investing in too risky a manner. Moreover, conventional planning puts your pre-retirement saving and post-retirement spending on autopilot. Thus, if your investments go south, you’re told to continue spending your targeted amount. This exacerbates what’s called sequence of return risk and is part and parcel of convincing you that riskier investing, which routinely comes with asset management fees, is the answer.
Two final concerns. First, the assumption that neither saving nor spending will change through time as you do well or poorly on the market – which will, in fact, happen -- means each conventional Monte Carlo simulation is calculating the wrong path of taxes and thus the wrong probability of plan “success.” Second, research shows that conventional Monte Carlo analysis is highly sensitive to the generally undisclosed return distributions embedded in the software tool being run.
Economics-Based Financial Planning
Economics-based planning is reality-based planning, not pie-in-the-sky, What’s Your Spending Goal?,” planning. Economics-based planning recognizes you can only spend what you can afford and not a penny more.
MaxiFi Planner is the only tool that implements economics-based financial planning. It does lifetime budgeting, determining what you can sustainably spend given your current and future income as well as cashflow constraints. Economists call this consumption smoothing.
MaxiFi considers housing, taxes, and other “must spends.” It then generates an internally consistent annual discretionary spending plan and an associated saving plan. The plan maintains your family’s living standard (discretionary spending) through time. To repeat, this is realistic planning, not wishful thinking.
Lifetime planning that handles all financial decisions
Your life starts now, not the day you retire. New Retirement, in contrast, is by its very title, focused only on retirement. MaxiFi’s deterministic planning can answer any question at any stage of life that impacts your family’s future financial well-being: What if: I choose a different career? Pay off my student loans early? Switch jobs? Retire early? Downsize? Take Social Security later? Do a Roth converstion? Relocate to Texas? The list goes on.
MaxiFi’s deterministic planning is based on conservative assumptions about future returns. Certainty-equivalent planning is the term economist use for treating an uncertain world as a certain one. Specifically, it controls for uncertainty by using very cautious assumptions. New Retirement’s deterministic planning seems based on typical portfolio returns, not the Treasury Inflation Protected long-term real return available on the market.
With economics-based planning, each financial decision is assessed in terms of your bottom line – the impact on your family’s sustainable living standard? These answers are delivered in concrete today’s dollar terms – the impact on affordable additional annual spending. They aren’t presented as changes in the probability of staying solvent. Nor are they presented in nominal dollar terms that can make users think they will have massive amounts of future assets, which such projections primarily reflect the workings of inflation.
Internally Consistent Planning Is Critical
Unlike New Retirement’s deterministic planning, when you change assumptions, like contributing more to an IRA, MaxiFi’s deterministic planning automatically recalculates your affordable discretionary spending path – the one that smooths your family’s consumption. It does so extremely quickly – usually within a second. During that same second, MaxiFi is not just raising or lowering your future annual path of discretionary spending. It’s recalculating each year’s federal and state taxes, Social Security benefits, and Medicare Part B IRMAA premiums. It’s also recalculating your life insurance needs.
Hence, every time you run a MaxiFi profile, you know all its results – its discretionary spending, taxes, benefits, and insurance premiums are internally consistent. In contrast, New Retirement’s analyses appear internally inconsistent. The reason is they are made based on your original spending target, not on what’s now affordable. Yes, one can manually adjust one’s target. But doing so in analyzing a single financial decision is a guessing game that can take hours. It can take a lifetime if the household faces cashflow constraints, which is the case for most households.
MaxiFi handles cashflow constraints
A cashflow constraint is when desired spending exceeds the cash you can access without going into debt. Roughly two thirds of U.S. households face cash constraints at some point in their financial lives. Given the recent extension of required minimum distributions from retirement accounts to age 75, this number is likely to grow even higher. Therefore, getting cash flow right is paramount, and it’s critical to understand how each program handles this problem.
New Retirement’s planning approach (like that of all other conventional planning software) requires endless trial and error to avoid a spending path that requires borrowing to spend. MaxiFi’s advanced algorithms handle cashflow contraints in that same second needed to recalculate a full lifetime financial plan. Specifically, MaxiFi reduces your spending in years to accommodate your cashflow constraints. But it does so starting as early as possible so that your household’s living over time is as stable as possible.
Maximizes Social Security, minimizes lifetime taxes
Unlike New Retirement, MaxiFi does robo-optimization. Click on its Maximization button and it will maximize whatever profile you’ve constructed. Maximization references considering all Social Security collection strategies and retirement-account withdraw start dates to find the combination that delivers your household’s highest lifetime spending. You can also further optimize your plan on a manual basis. Each profile you set up can be compared on a side-to-side basis with any other.
Getting Social Security right can, in particular, deliver tens to hundreds of thousands of dollars in additional lifetime discretionary spending. MaxiFi’s Social Security benefit code is second to none in detail and accuracy. Indeed, it goes far beyond the tools the Social Security Administration provides on its website.
Conventional tools like New Retirement can explore Social Security optimization, Roth Conversions, and optimal timing of retirement account withdrawals. But, to repeat, MaxiFi does so ensuring your spending, taxes, and insurance premiums remain internally consistent. For example, if you model retiring early, MaxiFi automatically lowers your spending, federal and state taxes, and, as appropriate, Social Security benefits, benefit-taxation, and Medicare Part B (IRMAA) premiums.
Life insurance calcs that protect survivors' living standards
Setting arbitrary spending targets, as New Retirement and other conventional tools require, means being advised to buy enough life insurance to cover these supposed spending “needs.” MaxiFi’s life insurance suggestions are based on actual spending needs – what’s needed to preserve your household’s sustainable living standard for survivors.
Life insurance isn’t, of course, free. MaxiFi adjusts its spending suggestions in light of these costs, which, in turn, impacts required annual life insurance amounts. Here, again, internally consistent calculations are critical. So too is MaxiFi’s Contingent Planning – accounting for changes in housing, earnings, childcare, etc., when a household head or spouse/partner passes.
MaxiFi’s Living Standard Monte Carlo® dynamically adjusts spending
New Retirement’s Monte Carlo simulations, as with other conventional tools, assume you will spend at your desired retirement target no matter how poorly or well your assets perform. As discussed above, a “safe” plan is one with an 80 percent or higher probability of avoiding going broke. But who wants to have even a 1 percent chance of losing every penny except Social Security, be that at age 95 or age 65.
MaxiFi’s Full Risk Investing simulates what people actually do or should do – adjust their spending in light of how well their assets perform. MaxiFi’s Full Risk Investing shows you the range of living standard trajectories you can expect based on how aggressively you invest and spend through time. Full Risk Investing not only shows you your upside and downside living standard risk. It compares upside and downside trajectories for riskier and safer strategies. These strategies involve two decisions – how aggressively to invest through time, but also how aggressively to spend through time. Like aggressive investing, aggressive spending can produce substantial downside living standard risk.
MaxiFi also includes a unique approach to Monte Carlo, called Upside Investing. It’s designed for investors who want to set a floor under their living standard, but still invest in the market. MaxiFi is the world’s only software that helps you establish, not an income floor, but a living standard floor. And it shows you the trade-off between a higher floor and a lower upside (or vice versa). Most households want to invest in the market. But they also want to sleep at night knowing their basic living standard is secure. MaxiFi’s Upside Investing eliminates downside living standard investment risk while providing you with a potentially substantial future living standard upside.
Conclusion
Our country has thousands of economists who specialize in finance. It has some of the very best finance and economics departments in the world. It has outstanding journals in economics and finance. Eleven Nobel Laureates have been awarded to economists for work in finance. If conventional planning made solid economics sense, it would be taught in our top business schools, it would appear in articles published in top finance and economics journals, and it would be the basis for Nobel-prize-winnng research. Unfortunately, it’s not. It’s simply a slick investment sales gimmick – one the industry should abandon for its own sake if not that of its clients’.
Related: MIT’s Superb Economist, Amy Finkelstein: Rebooting American Health Care