How To Find Your Best Plan
My letter to my students' clients
Good afternoon!
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Economics-Based Financial Plans are Different
A few days ago in a note, I foreshadowed today’s post about the information necessary to build an economics-based financial plan: where to start and what you need to assemble a functional plan. I have had a lot of experience conveying the DIYing of a financial plan.
For several years, I’ve assigned my undergrad students the task of finding a household and working with them to build a financial plan. In every case, students are working with individuals who have full-time jobs, are more likely than not early in their careers, and have limited savings and investments. These “clients” are singles, couples, and most with limited financial investments. They are not wealthy and wouldn’t be a sales target of an investment company.
It quickly becomes a learning experience for everybody, particularly households who, when approached, were curious about financial planning and what it means to them.
Who wouldn’t want to know, at a given moment, the answer to the question: “What is my highest achievable living standard today?” Particularly, given the alternatives are plans built around “budgeting” and conventional planning.
The path I teach, economics-based planning is richer, internally consistent, and built on household economics which vary across households.
Conventional planning is built to sell financial products. It does not offer itself as a decision tool, or assess a living standard objective.
How a Living Standard Objective Presents Itself
Many households are like the Diaz family who is featured in chapter 3 of our book.
The Diaz’s Plan Provides the Budget Cap
Most households value knowing their highest attainable living standard, which manifests itself as a spending cap for next year. One way to conceptualize the Diazes spending is the breakdown in this table,
Through the planning process, we can identify housing costs, taxes, retirement contributions, and estimated life insurance premiums.
What is initially unknown is how much additional spending (all other items included like utilities, groceries, and spending for fun) the Diazes can afford for the next year. Is it $50 or $100k? The question mark in column A of the table above has an answer behind it. Economics-based financial planning solves the spending cap question.
The Diaz spending cap is an additional $68,000 for this year.
Where does that number come from?
It comes from the economics surrounding the life cycles of Charles and Gabriella.
Here is the intuition:
Households have income, live in a world with present-day taxes and future taxes, and have consumption needs and wants. Consuming more today, means less consumption in the future and lower taxes because there is less savings and less investment returns. Consuming less today means a lower living standard today, more savings, and more investment returns subject to future taxes. Longevity plays a role because over-consuming today, “gorging” could mean starving tomorrow if one lives too long. Even with an income, starving today means either gorging tomorrow or leaving money on the table when one dies.
In general, the spending cap for the next year and subsequent years optimizes the living standard across the ages of the adults in the household, recognizing that spending and saving behavior today and during retirement years are interrelated.
As the economist
puts it,1“…What households can afford to spend depends on what future taxes they face, but what future taxes they face depends on what future spending they do, and, yes, this is a complex chicken and egg problem.”
The Good News
The problem is solvable mathematically, and there is software that does the math. Easy to use and what I use with my students. Charles and Gabriella’s annual living standard objective include the balance of the time until their twins are adults, then their time afterward together until their max age. In their case, the plan is producing the annual spending cap and savings recommendations.
The bonus of economics-based planning can be used to answer other questions such as the best time to retire, when to take Social Security retirement benefits, and even help judge whether a job in Detriot is a better financial choice than Miami. If the question is whether a Roth conversion make sense? It can do that, too.
Even better, the spending and savings recommendations are derived from household financial resources, and most households know what those are. Knowing the actual spending last month or last year is not a requirement. So, for instance, except for a mortgage or rent, very little current spending information is required to learn a household’s annual, optimized spending cap for each of the next few years.
What do I need to assemble for an economics-based financial plan?
To be more specific about what a household needs to run its financial plan, I have attached a letter that I send to my students’ “clients” so they know what to expect and the information they need to assemble. Items A, B, and C on page 3 handle the information needs of most people. Your information needs as well.
If you want to learn how to use your information and run MaxiFi software, you have three (3) paths. Read chapter 3 of our book, which is included with a paid subscription. Sign up for a 1:1 coaching session on Teach:able, or join my “How to build your economics-based financial plan and interpret the results using MaxiFi software.” That, too, will be on Teach:able and available within the next week.
See Kotlikoff’s criticism of conventional planning software like Boldin.
I found your approach to economics-based financial planning refreshing, especially the focus on living standard optimization. How do you suggest households adjust their plans in response to unexpected financial shocks like job loss or medical emergencies?
Have you looked at Pralana's Retirement Planning tool? It is the best high-fidelity tool I have encountered. I, too, have used MGP & Fidelity's tools as cross-checks but they lack the granularity required for a high-confidence plan. Your comments?