Laurence Kotlikoff on Financial Malpractice and Economic Thinking

Laurence Kotlikoff on Financial Malpractice, Economic Thinking, and
Pricing Out Passions

by Shelley A. Lee

He’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

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 like giving somebody a medical checkup in one minute. Fast and easy doesn’t necessarily mean helpful.

Are you saying the approach is just too simplistic?

That—and that it has no true objective. What are the criteria for what’s trying to be achieved? Forget the online tools—if I go to a financial planner, one of the first questions he or she may ask is, “What is your spending goal in retirement?” That is just totally the wrong question. I don’t understand why more planners don’t ask themselves why they ask that question. Unfortunately, it’s based on this ruleofthumb study, done by Georgia State University and AON every year since 1988, which has gotten too entrenched in the planning world’s mind.

What’s wrong with the study?

It comes up with replacement rate based on current income—the tired old “75 to 80 percent of your preretirement income is what you’ll need in retirement.” It’s totally inappropriate for most households and is generating wildly high recommendations for savings and insurance. The methodology is just mindboggling in how erroneous it is. Of course, a lot of financial service companies have a vested interest in getting people to buy more investments and more insurance. People are induced to buy financial products that aren’t right for them and they get focused on the probability of making the target, as opposed to the probability of not making the target. There’s also a huge conflict of interest for a major financial service company funding “research” that is designed to frighten and mislead people into buying products.

What about your own conflict of interest? You do sell a software program.

Yes, clearly I’m not a disinterested party. So I guess you could say I can’t be totally objective on this issue. I do think the software is state of the art because it embeds economic principles. There are other economists doing research on similar tools. In fact, any economist with time and money could come up with the answer to consumption smoothing. There aren’t five different ways—there’s really only one. The point is what economics has to say about these financial planning issues using a dynamic model, not a static one.

What is the advantage of a dynamic model?

Essentially, dynamic programming works by making general plans, starting with the household’s last year of life and working backward to the present. Once you use this type of technology, you can figure out many things relating to living standard. What if the client takes Social Security at age 70 instead of 65? Which accounts should they withdraw from first? What are the implications if the client significantly downsizes in housing? How will different tax and Social Security structures in the future affect living standard? What if the client goes back to school and gets an M.B.A.—will it pay for itself in future earnings? What is the impact of Medicare Part B expenses? Technology that can give you answers to these questions in ten seconds is a revolution. Most people care about their living standard more than their portfolio holdings.

How does dynamic modeling let you “price out passions”?

The software can tell you what happens if you want to have another child, or what happens if you get divorced, or if you want to retire early and go fishing. Now you know how much it will cost you to go fishing. Basically, what are you willing to swap for another child, another house, a charitable contribution, a gift to your kids? Think of it as a way to figure out how much love will cost you.

What do you hear from financial planners about your comments on financial malpractice? You’ve written that

rescue much sooner. We’re to blame, too. Most economists have preferred the comfort and safety of their research.

What about the thesis that economics is the dismal science and economists a bunch of sourpusses and naysayers and that at least planners get clients focused on going toward the future with some confidence and optimism?

That’s fine, but too often clients are prescribed solutions for some future goal that are too risky. Planners sit down and have nice long conversations and learn the names of their clients’ children, but in the long run they don’t benefit clients if they put them in the wrong solutions because they’ve asked the wrong questions. Clients might hit the target dead on, but often only by accident.

Only about 15 to 20 planners have bought your software. Is anybody listening? How is this revolution going to happen?

One person at a time. Clients are asking economists for advice by buying the software themselves. What planners need to recognize is that the software can be more powerful than they are. The real question is whether planning will get on board with the dynamic modeling approach, or whether clients will push them to it out of frustration. If clients start walking into planners’ offices and saying, “Gee, I’m using this software and getting totally different answers than you are,” the revolution could bubble up. Or it could eliminate the planner altogether.

I’m not attacking planners individually. I’m attacking the methodology they use. Given how critical I’ve been, most of those I’ve talked to have been reasonable and thoughtful. I’m saying it in strong terms so they’ll listen. I think planners are both frustrated and victimized. The software that many planners use is based on high school algebra, when what they need is rocket science. The big companies bear more of the blame—of course, you expect them to be profit oriented and not focused on advice, just the way drug companies are more concerned with selling drugs than with patients’ health. Economists have known for decades that what the industry is doing is horrific when it comes to personal finance. We should have come to the

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