In recent columns we've criticized conventional financial planning. We said it   engaged in target practice, promoted consumption disruption, solicited risk, provided quick but erroneous "solutions," and made outrageously bad saving and insurance recommendations. In short, we've suggested that advice givers, particularly large marketing-driven financial institutions, are engaging in financial malpractice.

The Oxford Dictionary defines malpractice as "improper, illegal, or negligent professional activity or treatment." We don't suggest there is anything illegal about the advice being dispensed.   We do believe it is improper and negligent.  

When it comes to providing financial advice, everyone from the neighborhood financial planner to TIAA-CREF has a fiduciary obligation to provide the appropriate "standard of care." Economists have spent a century defining and refining the proper standard of care when it comes to financial advice.   But the actuaries, who have developed conventional planning tools, have yet to make contact with consumption smoothing  ¬— the core principal underlying the economic theory of saving, insurance, and diversification.

Much of the blame here lies with economists.   They've ignored the bad advice being delivered, preferring the comfort of their research work.   Imagine MDs doing nothing but research, never leaving their laboratories. The public would be forced to turn to untrained medicine men for their health care.

Economists are now in a position to prescribe financial behavior, not just describe it. In particular, they are in a position to apply dynamic programming, an advanced mathematical technique that is essential for smoothing a household's living standard without putting it into debt.   Unfortunately, dynamic programming is not something actuaries learn in school.

To see the need for dynamic programming, take Dan and Elaine Grunberg -- a middle-age household that has significant "off-the-top" expenditures, including mortgage payments, college tuition, and 401(k) contributions. Since the Grunbergs can't borrow against their future 401(k) withdrawals, they are forced to accept a lower living standard before retirement.  

Let's make this concrete.   Dan and Elaine are 35, make $50,000 each, have two kids, ages 10 and 13, a $300,000 house with a 20-year $2,000-per-month mortgage, a $3,000 annual property tax bill, and $3,000 in other yearly housing expenses.   Each spouse has $100,000 in a 401(k) and makes annual contributions of 5 percent of his/her salary, which triggers an equal employer match.   The Grunbergs plan to spend $30,000 per child per year for four years of college.   Finally, the Grunbergs have $50,000 in regular assets, plan to stop contributing to and start withdrawing from their 401(k) at 59, and plan to retire at 62.

According to ESPlanner (Kotlikoff's company's software), which uses dynamic programming, the household's living standard (per equivalent adult) is $26,241 prior to getting the kids through college (age 58) and $31,333 thereafter.  

Does this mean consumption smoothing isn't important for the Grunbergs? On the contrary, it's even more important. The Grunbergs face not one but two consumption smoothing problems.   They need to smooth their living standard prior to age 58, and after age 58.   And they need to ensure that the rise in their living standard at 58 — their consumption disruption — is as small as possible.

To smooth their initial living standard, the couple need to accumulate $101,985 prior to the oldest child starting college.   Over the next seven years, the Grunbergs spend down this wealth on college tuition and on their own living standard.   Only when they make their last tuition payment at age 57 can they finally start saving for retirement, which they reach with $114,713 in new savings.   These assets, together with Social Security benefits and 401(k) withdrawals, support their higher living standard in retirement.

Dynamic programming works by making general plans, starting with the household's last year of life and working backward to the present.   The plan for the next to the last year of life is based on the plan for the last year.   The plan for two years before the end is based on the plan for the next to the last year, etc.

This technique turns out to be critical for figuring out the intervals during which the Grunbergs are constrained from borrowing as well as determining how much needs to be saved during each interval.   Dynamic programming is also needed to evaluate the advantage of additional retirement account contributions.  

Cash-constrained households--- and few aren't--- face a tradeoff from extra contributions, namely a lower living standard now but a higher one later.   In the Grunbergs' case, contributing an extra $1,000 each to their 401(k) plans lowers their annual living standard before age 57 by 2.6 percent and raises it thereafter by 4.5 percent.   This is an 8-second calculation with the right dynamic program, but an impossible calculation without it.  

So what's our bottom line as we conclude this series on financial advice and consumption smoothing?   It's an appeal to advice givers to either do it right, or get out of the business. It's also a warning to the public that most professional advice is not worth the taking.

On the web:

---URLs to earlier columns in the series

Wikipedia on "dynamic programming"