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SMay 2, 2006

Why Consumption Smoothing Is Important

Nearly 11 years ago I sat down with Ken Bingham, a broker friend at Paine Webber. I told Ken that Peter Lynch had written an article for Worth magazine declaring you could be 100 percent invested in common stocks and withdraw 7 percent a year, forever, because stocks returned 11 percent a year.

"This brings me," Mr. Lynch had written, "to an investment strategy I described in my second book, 'Beating the Street.' If I convince you of its merits, you will never again buy a bond or a bond fund, and you'll stay fully invested in stocks forever."

I was sure Mr. Lynch was wrong. Ken Bingham had his doubts, too. Ken and I spent an afternoon putting portfolios through their paces in different historical periods. We proved what I suspected: If you followed Peter Lynch's advice, you had a significant chance of going broke.

I like to think that column--- and all the columns on safe withdrawal rates that followed--- made a small contribution to hastening a major change in financial planning. The change was the introduction of stochastic (probability-based) analysis, rather than deterministic projections. Today, we see the stochastic approach most often in the Monte Carlo simulations of future asset returns. The most familiar examples are on websites like www.financialengines.com or in the retirement tester on the T. Rowe Price website.

This isn't an academic matter. What's at stake is our understanding of the risk involved in our retirement plans.

The recent column series on consumption smoothing was written in the same spirit. I wanted to be on the front line of reporting a challenge to commonly accepted financial planning practices. Even more, I wanted to be on the front line introducing a better idea, consumption smoothing.

To do it, I enlisted Boston University economist Larry Kotlikoff, a prime mover in the field, to co-author the columns. I've followed his research for more than a decade, and we've written a book together, "The Coming Generational Storm" (MIT Press 2004). He had also created the first software powerful enough to do the required computation. I don't have a financial stake in that software. He does.

Sadly, his financial interest caused some readers to see the column series as an "infomercial." If you are one of those readers, I can assure you that our intention was to advance an idea. It was not to sell software.

My hope is that the best and the brightest in financial planning---like the people who write articles for the Journal of Financial Planning--- will start to use the consumption smoothing approach with their clients.

How will our lives improve if consumption smoothing becomes the foundation of financial planning? Here are three major ways:
  • Planning for the future will no longer seem impossible because our life projects will be considered interactively rather than as unrelated parts. The consequence will usually be a lesser need to save and insure than conventional planning suggests. That means more people might actually follow a plan and succeed.
  • Consumption smoothing allows us to see the impact of different decisions on our lifetime standard of living. We can actually compare decisions such as downsizing, moving to a different state, delaying Social Security benefits, investing in a Roth IRA instead of an IRA, paying a mortgage off quickly or slowly, etc.
  • Because it focuses on our ability to sustain a standard of living rather than asset accumulation, consumption smoothing gives us a direct window on what's truly important--- the uses of our money throughout our lifetime. While the first two improvements are important advances, seeing money as a tool--- rather than an end in itself--- is a benefit with a spiritual as well as material dimension.
It opens the door to more manna, less mammon.

On the web:

Consumption Smoothing series

The Portfolio Survival Reader

Sunday, October 1, 1995: "Dangerous Advice from Peter Lynch"

Filed Under: Consumption Smoothing