Do you have recurrent idle thoughts, such as "If I had a million dollars, I would…" or "If I could just increase what I can spend by…"

We do too.

But we think there is something better to do than sit around waiting for money to appear. We can do some financial planning. Do it, and we may be able to raise our standard of living without breaking a sweat.

The question is what are the moves that work? And what moves don't?

Think about some of the questions we face.   This job has a high starting salary, but low earnings growth.   That one has the opposite.   This mortgage has low payments now, high ones later.   That mortgage has fixed payments.   Contributing to an IRA lowers current taxes, but raises them down the pike.   Taking Social Security early means receiving lower benefits, but for more years…

Worse, all these decisions are interconnected. Change one thing, and you change another. Take IRA contributions.   The more you put in, the more you can take out.   But your withdrawals are "taxable income." Take enough, and you'll have to pay income taxes on your Social Security benefits.   If you contribute to a Roth IRA, you'll pay more taxes now but avoid taxation later.

The timing and amounts of your IRA contributions and withdrawals interact with the timing and level of your Social Security benefits. That determines how much of your Social Security goes back to Washington.

So how do we figure out what's best?

The answer comes from economics. Combined with high powered math and modern computers, it can determine how these and other decisions affect your sustainable living standard, using an idea called consumption smoothing. Rather than focus on a single economic project--- like buying a first or second home, paying tuition at Stanford or retiring early, projects that will affect everything else in your life--- consumption smoothing synthesizes every major life decision and evaluates its impact on your lifetime standard of living.

Once you've plugged in your special spending goals and housing plans, consumption smoothing software (such as ESPlanner, marketed by Kotlikoff's company) will determine how much to spend each year to achieve a smooth living standard.     You can also use such software to find ways to maximize your living standard.   This type of analysis has the potential to revolutionize financial planning. It's at least as significant an advance as the introduction of probabilistic Monte Carlo modeling that financial planners now proudly display to clients.

Want some proof?

Here's what consumption smoothing can do for a hypothetical couple, Jessie and Josie Jay.   The Jays are 40, married, live in Wisconsin, make $40,000 each and have a 6 year old named Jenny and a 10 year-old named Jamie.   The Jays also have $150,000 in regular assets, a $300,000 house, and a $150,000, 20-year mortgage with a $1,000 per month payment and other commensurate housing expenses.  

Jessie and Josie plan to pay college expenses for the little Jays of $20,000 per year each (in today's dollars) for 4 years.   They also plan to retire and start collecting Social Security at age 62.   Being conservative, the couple invests only in TIPS — Treasury Inflation Protected Securities yielding 2 percent above inflation.

Consumption smoothing recommends the couple save $3,452 this year and consume (apart from housing expenses) $45,214 until Jenny goes to college, $38,671 thereafter until Jamie goes to college, and $31,551 once both kids have left the nest.   These numbers are all in today's dollars.  

Is that smooth and stable? You bet. In adjusting recommended spending to the number of mouths to feed, consumption smoothing takes into account economies in shared living and the relative cost of children. Two can't live for the price of one. But two don't cost twice as much as one, either. And there is a reason it's joked that children are cheaper by the dozen.

Although total spending changes over time, consumption smoothing delivers a stable $19,719 living standard per adult. It does this year in and year out.   (This is the amount of spending Jessie or Josie would need as a single person with no children to enjoy the same living standard he/she enjoys in the household.)

That's nice, but can they do better? Yes.

Now suppose Jessie and Josie open up IRA accounts, contribute $3,000 a year each through retirement to these accounts, and withdraw their balances smoothly starting at age 65.   Doing so raises their living standard to $20,197 — a non trivial increase.

The Jays can do even better — achieve a $20,675 living standard — by withdrawing all of their IRA balances between ages 62 and 67 and electing to start receiving Social Security benefits at age 68.   This allows the Jays to limit taxation of their Social Security benefits, which depend on the amount of taxable income, including IRA withdrawals.   It also lets the Jays take advantage of the terrific increase in Social Security benefits provided by Uncle Sam for waiting to start benefit collection.

Finally, if the Jays move to Texas, with its zero state income tax, and maintain their same housing expenses, they can get their living standard up to $21,690.   This is a 10 percent increase over the original $19,719!   It's not hitting the jackpot, but it's a huge improvement, given that it costs them nothing to make these decisions.  

This increase isn't for a single year. It is a benefit, in real dollars, that they enjoy every year from the start of their plan, age 40, until they die.

None of these results would be suggested by conventional financial planning. It would suggest a college savings project that would crush their current living standard. It would suggest a separate retirement savings project that would lower their standard of living while they were working, and it would miss the impact of lifetime changes in taxes.

Can anyone do these calculations in their head? No way. But a good laptop with consumption smoothing software do it in seconds. It can also provide Monte Carlo simulations that show not just the expected level of your living standard, but its potential variation as you age.

On the web:

Previous columns

Professor Laurence J. Kotlikoff's webpage

ESPlanner software webpage

The Coming Generational Storm (at MIT Press)

The Coming Generational Storm (at Amazon.com)