Saturday, February 26, 2005

Retirement Planning

Charles Kirk runs an interesting and broadly informative investment weblog (even for non-traders) called thekirkreport. He recently referenced ESPlanner. I first ran into the ESPlanner in Larry Kotilikoff’s book The Coming Generational Storm. Impressed with the book, I took a look at the ESPlanner website. They have posted numerous (though somewhat self-serving) research papers and articles on their “economic” approach to financial planning and the development of their financial planning software Economic Security Planner (ESP). The economic approach to financial planning seeks to define the highest affordable and sustainable living standard through time and in the event of an untimely death. The software uses savings rates and insurance decisions through-out lifecycles to optimize the living standard. Traditional planning approaches use targeted income or spending goals in retirement to set appropriate level savings rates to achieve those goals. The ESPlanner uses dynamic programming. This process deals with optimal solutions in multiple stage decision-making processes. I found the intuition behind this approach interesting. The academic and economic pedigrees as well as the quantitative process behind this alternative seemed attractive as well. So, like Charles, I invested my $200 to take if for a spin.

According to the research material the basic conceptual differences between this software and traditional planning software is a) how it determines expenditure targets, b) its treatment of demographics ( this program assumes some economies of scale for familial expenses and c) how it handles borrowing. Given the degree of uncertainty of planning items not accounted for in this model I felt that items b and c were somewhat trivial.

There are substantial forecast risks that are not well addressed by this or other financial planning products. Healthcare or long-term care costs and future employment risk are two examples. Other inputs and assumptions might also be more effectively managed stochastically, though complexity then becomes an issue. For instance, inflation and mortality risk are handled on a deterministic basis by ESP. These two elements can blow any plan into irrelevance in short order and a probablistic perspective on these elements might be useful. General investment risks/returns can be handled deterministically or stochastically via the monte-carlo enhancement available via the monte-carlo upgrade.

The model provided lots of flexibility in terms of defining future financial events and it was relatively user friendly from an input side. Descriptor screens were functional but not extremely explicit. After spending an afternoon inputting data and selecting assumptions, I was somewhat unfulfilled when I looked at the results. The ouputs of the program are chronological recommendations for spending, savings and insurance presented in excel using tables and graphs. As best I could interpret I should/could be spending more in some years. The variability in annual spending/borrowing didn’t make intuitive sense to me even though it makes economic sense. This product could be much enhanced with some additional guidance on how to interpret the output. Someone with a larger appetite for details and an undivided interest in a range of possible outcomes could certainly get their money’s worth from this application. For me though, the elegance of the concept worked better than its execution in reality.

I couldn’t shake the feeling that, despite what the forecast showed… I am not as well prepared for an uncertain future as I should be. Maybe this is because I know with certainty that I have mis-specified the future. The limitations and general ineffectiveness of any of these planning tools in the face of uncertainty allows us all to rationalize why our current habits are sustainable.

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