Pricing Out Passions

byShelleyA.Lee

e’s been a vocal critic of financial planning, even writing that “the financial institutions and advisers conveniently

match our needs to the securities they’re peddling,” that “most professional advice is not worth the taking,” and that conventional financial planning “makes outrageously bad saving and insurance recommendations…putting a pretty face on risk and sell[ing] it.”

Laurence Kotlikoff acknowledges that he hasn’t been particularly polite when it comes to pointing out what he sees as the bad thinking and worse methodology that many financial planners use: “I’m being critical in strong terms so they’ll listen.” What is it he’s saying and why should you listen? He’s not indicting financial planners, he says, but finds that too many approach financial planning through the targetedspending approach, which differs fundamentally from the economic approach—namely, consumption smoothing. Kotlikoff believes that the targetedspending approach may be resulting in too many consumers actually saving too much. Some prominent experts agree with his underlying thesis—simple “static” models use “pure rules of thumb—and the rules of thumb are in error,” says Wharton professor Kent Smetters in a Knowledge@Wharton article. And according to Olivia Mitchell, another Wharton professor and executive director of Wharton’s Pension Research Council, the standard 75 percent to 85 percent replacement rate is a serious shortcoming—“figures that are made up out of thin air.”

In addition to being on faculty at Boston University and previously at UCLA and Yale, Kotlikoff is a Fellow of the American Academy of Arts and Sciences and Research Associate of the National Bureau of Economic Research. He has served as a consultant to the International Monetary Fund, World Bank, and numerous foreign and domestic government agencies. He also is the author or coauthor of 11 books and hundreds of professional journal articles. We recently talked with him about where he sees financial advice going wrong.

How long have you been concerned with what you refer to as “financial malpractice”?

I’ve been studying personal financial decisions, in particular savings and insurance adequacy, since graduate school 30 years ago. It became apparent to me, and many other economists, way back that what economics has to say about personal finance is radically different from what financial planning has to say. Indeed, it’s the direct opposite.

Where does the thinking between economics

and financial planning diverge?

Financial planning doesn’t incorporate anything from economic theory and science, which is focused on consumption smoothing—that individuals should smooth out their living standard over a long period. It’s about the level, the smoothness, and the risk and variability of your

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living standard. Conventional financial planning doesn’t even try to achieve this. It sets targets for people or, worse, has them set their own. This notion that people can set targets is promoting consumption disruption and is completely contradictory to what economics recommends. Conventional planning’s use of spending targets also distorts its portfolio advice. The idea that you can set targets independent of what those imply for your current living standard is not being examined at all by conventional methodology in financial planning. The biggest offenders are online calculators from financial service companies. They’re totally useless. One wellknown online service asks only five questions—it doesn’t even ask your spouse’s age or whether you have children. It’s lik