A Financial Plan For Your Entire Life | #417 (Dr. Paul Kaplan)

28:47What's the probability of me living to age 110, let's say? It's pretty small. I don't want to hold on to my assets just because I might live to 110. We call this a rescheduling factor. If you start with a, let's say, a smooth consumption curve, we're going to take consumption at the end, extremely high ages, which are very unlikely that you're going to live to, and we're going to spend more when you're younger, when, you know, it's more likely you'll be alive to enjoy that consumption. If you do want to take the annuity route, then what is the fair price of an annuity? Well, to know that, you have to have a model of survival probabilities.

29:27How do you actually take all this and solve utility maximization problems like we've been talking about that incorporate all of these different pieces? In a lot of the life cycle finance literature, they have some really complicated ways of doing that. Something called dynamic programming. And anyway, so they don't have like a formula for it. They just have like a method of solving for it. we made some simplifying assumptions in the book that do allow us to actually give a mathematical formula for how much your level of consumption be year in and year out, depending on market returns. Your exposure to those market returns depends on your risk tolerance.

30:11So if you have a very low level of risk tolerance, it's going to be less volatile. If you have a high level of risk tolerance, it'll be more volatile. How do spending rules, you know, the commonly used 4 % rule, interact with lifestyle optimization? One way to look at life cycles for dance is the critique of those methods. So those methods are ad hoc. They have no economic theory behind them. The 4 % rule in particular came from a study done decades ago using historical data. And then every so often somebody reruns the study and they come up with a different number. We don't think that's a very useful exercise.

30:49We think investors should be advised to take a holistic way and to focus on their consumption and not on a spending percentage. That's a great critique and I think it does make a lot of sense. How would the spending path of a retiree using a life cycle model like we've been talking about, compared to somebody using something like the 4 % rule? In chapter six of the book, we present all the math and everything behind that. So if the person is retired, you know, they're living off their savings that are invested and according to their, you know, the asset allocation being according to their risk tolerance, then year in and year out, they're going to vary their consumption basically on the performance of their portfolio versus, say, like the 4 % rule.

31:37you spend the same amount of money year in and year out adjusted for inflation. If market returns go very badly for you, particularly at the beginning of your retirement, you can run out of money. I mean, a lot's been written about that, but why run out of money? Why not have a flexible spending rule that's grounded in good theory instead of taking the risk of running out of money? Could there be a set of parameters in a lifecycle model that ends up looking like the spending path of something like the 4 % rule, like if somebody really didn't want to have variable consumption in retirement? To get to an absolutely flat consumption like that, two things would have to be true.

32:20Number one, their elasticity of intertemporal substitution, those consumption preference parameters, more importantly, would be the subjective discount rate. If the subjective discount rate equaled the market rate of return, then regardless of the intertemporal elasticity of substitution, that would result in a flat consumption rule. The other condition, the person would have to take no certainty. They would have to invest all their money in riskless assets. But of course, the 4 % rule is all about spending your money if you have risky assets. So the conditions you need to get to that spending rule, you are completely at odds with the assumptions.

33:03Yeah, that's interesting. How does the path of retirement spending for someone using the lifecycle model interact with annuities? If you can annuitize, you get those mortality credits. And also it means you can plan on a smooth level of consumption that actually does not depend upon the possibility that you might not live for an old age. So, you know, I was describing before, if you don't have annuities, your planned level of consumption might be for age 110, it's probably going to be pretty small. Whereas if you have annuities, your planned level of consumption at age 110 is just going to be on the same curve as your whole life.

33:43So annuities allow you to create that smooth consumption pattern, then don't have to worry about when you're going to die because that's all been baked into the annuity. Should consumption be an input or output for financial planning models? It should be an output, as we've been discussing here. In a life cycle model, any life cycle model, consumption is the output. That of course makes sense. It could almost be treated as an input based on the parameters that somebody specifies. If someone has a strong preference for current consumption, that's sort of making consumption and input, I guess, as a second order effect of specifying their time preference.

34:27Does that make sense? Preferences are not the same thing. I mean, the preferences are the inputs. The consumption level is the output. It would violate the basic assumptions of the model to say that, oh, I've got this level of consumption that I want to have because the level of consumption should be the result of the preferences, not a substitute for the preferences. Yeah, it's interesting to think about because usually in financial planning, it's like you meet with a client who is spending this amount and you're kind of working backwards from there, which is just very different from consumption being an output.

35:02Tom and Zurich, my co-author on the book, we also co-authored a paper in the financial planning review, the hybrid model. And one of the things we do to illustrate, we do illustrate numerically the difference between doing things in this ad hoc traditional way versus in an optimal life cycle way. So pre-retirement, it's saving. So that's called savings smoothing. That means at each year, as your salary changes over time, that would make your savings different over time. But it would have nothing to do with your consumption. It would just be related to your salary. And then after you retire, there's a rule that says, take your final salary pre-retirement and take 90 % of that and spend that for the rest of your life.

35:49Those kinds of rules lead to very suboptimal results. We've talked a lot about lifecycle finance and a bit about asset allocation, touched on asset location. How important is asset location? Asset location is important because holding stocks and bonds in a taxable account is very different than holding them in a tax-advantaged account. The return on stocks typically comes more in the form of capital gains. and capital gains are typically taxed at a lower rate than ordinary, you know, the dividend income. And then with bonds, you know, they mainly pay interest, which is taxed at the ordinary rate.

36:31So the kinds of after-tax behavior of the same asset in two different accounts can be quite different from each other. How does optimal asset location deal with the uncertainty of future asset class returns? The same way that any other asset allocation model does. Every asset allocation model has baked into it assumptions about the uncertainty of future returns. Why is solving asset allocation and location sequentially a mistake? It's not a sequential problem. You have to invest the money. It's a joint decision. How do I invest between the taxable and the tax advantaged. One of the things we do in our net worth optimization framework is that we take that all into account.

37:19So we look at stocks, how they return in the two different accounts and how bonds, how they return to the two different accounts. All that is taken together simultaneously. So you get to an optimal, not just an optimal asset allocation, but also an optimal asset location. You can't get there if you do them sequentially. just in terms of the magnitude of the impact of optimal asset location if you didn't solve for it in one case and did in another how much of a benefit are you giving up by not solving for optimal asset location i can't really say that unless we're talking about like a particular numerical example where we can show the difference but we do know with any kind of optimization framework, it's suboptimal to optimize in isolation.

38:06You're always going to get to a better place if you do one grand optimization that taking everything into account. Why is it important to have a target asset allocation before selecting funds? As allocation is really important in the investment process. I'd like to read a quotation from Markowitz on this. I had the opportunity some years ago to interview him, and I asked him a question about what's important to happen in investing since he did his famous mean variance optimization paper back in 1952. And then in 1959, he published a book which gave all the math and everything about how to do this mean variance optimization.

38:50He says, I think the most important thing that happened between 1959 and the present is that the notion of doing your analysis of asset classes in the first instance, this has become part of the infrastructure that we now rely on. In 1959, I had a theory, I had a rationale, and so on. Now we have an industry. So asset allocation is kind of what made Markowitz's theory into an industry. We recognize now that it's really at the asset class level are the basic drivers between risk and return. Sometimes we call the asset allocation decision the beta decision, the underlying drivers of return. And that when you pick individual managers of different individual funds, that's the alpha decision where you kind of decided on your asset allocation.

39:38And then you pick managers that you believe will add value without adding too much risk. You've made all of this seem very easy to understand, and you've explained it all in plain English, which is an incredible skill, and I'm sure our listeners will appreciate it. But underlying everything you've said is a tremendous amount of math and quantitative complexity. What tools can investors use to put everything we've talked about into practice? Tom and I, my co-author, Tom and Zurich, We believe it's really important to get these tools into software. In the end of our book, we have these calls to action on the industry, and one of them is develop financial planning software that is based on life cycle theory, rather than just sort of these ad hoc tools that we've mentioned before.

40:29Now, as a step in that direction, I've developed a spreadsheet that actually implements most of what we've talked about in the model, at least on the life cycle part about that. Now, the focus of the spreadsheet is on consumption and very high level asset allocation. The rest of the model, in the book, we divide the three parts. The parent model, which is the life cycle model, life cycle theory. The child model, which is the net worth optimization asset allocation model. And then the third part, which we haven't discussed too much here today, is what we call the grandchild model, which is basically how do you take the outputs of the child model and pick actual funds.

41:12And to pick actual funds, you have to come up with these alphas or these additional expected returns. And you also have to take into account the additional risk that you're adding when you use an active manager. You can stop just at the asset allocation level and just use index funds, in which case you're getting the beta effects, just the risk and return of the different asset classes. When you use active managers, you may or may not get an alpha, but you definitely will get more risk in the portfolio. And so that's what the grandchild model does. It manages all that. So if you like, I could just go and pull up the spreadsheet model.

41:51I would absolutely love that. So what I have in these yellow cells are all the inputs to the model. So the age, the sex, One of the features of the model, it's very easy to change a person's longevity assumption. That's, again, because of the model that Professor Malefsky recommends. It makes it very easy to do that. Then how far off do you want to model? And then we have these preference parameters, which ideally should come from some kind of profiling tool, but this is just a spreadsheet. So I just put some numbers in here. Your non-discretionary consumption is$50 ,000 a year. I break down your asset allocation of your current assets, between stocks, domestic stocks, global stocks, bonds and cash.

42:37When you retire, so you're going to retire at 66. What your current salary is, there's also a piece in here where you can include an employee match. In this example, you're contributing$15 ,000 a year and your employer is matching that at 50%. So in other words, the employer is adding$7 ,500 to your account each year. How much do you want to annuitize? Bequest preferences, again, they should come from, okay, what type of bequest do you want? Then we get into income. So we use a model here that was developed at Morningstar, where you basically, you put in a person's education level and their sex, and it comes up with a salary curve.

43:26That's cool. This part here, you put in your allocation of human capital. So your human capital here, I say it's 20 % as an equity exposure, 25 % of which is global stocks. And then my liability, I just said it's 15 % equity and 0 % global. And then it calculates for you. The bunch of numbers which are described in the book, so there's the match, it has built into us an estimate of U.S. Social Security. So if you want to use a model like this in Canada, we would have to substitute the Social Security model with the CCP model. Your financial wealth is$1.2 million. It calculates your net worth. This is your balance sheet, how much you have in financial wealth, how much you have and how much you have in net worth, how big your request is,$1.5 million.

44:22And then you go here. These little charts are probabilistic projections. We start with the most important one, which is total consumption. The heavy blue line, that's the expected value. In this example, we have consumption growing at an expectation at a constant rate. I think I have the rate here. So the growth rate is 0.45%, which is derived mathematically from the model. And then each of these things represents probabilistic forecasts. So if markets go really, really well, if the market is very kind to you, it shows you can really increase your consumption quite a bit. If markets go very, very badly for you, well, you still have something you can consume, but you consume a lot less.

45:10Unlike the 4 % rule, it doesn't go to zero. You still have something. You modify the amount of money you spend. The next one is the financial wealth. The shape of it makes sense. You grow your financial wealth while you're working, and once you retire, these numbers come down. And again, the top one is the 95th percentile. So there's a one out of 20 chance things will be this good, and there's a one out of 20 chance things will be that bad at the bottom. So we think this kind of output is important in financial planning. Give the investor a picture of how their consumption and financial wealth might change over time.

45:49The next picture is human capital, which you can see human capital, remember we said with 20 % equity, it's a lot less riskier than your financial wealth. Mainly it goes down over time, That makes sense because human capital is the present discounted value of your future salary. So as you get older, you have less and less future salary. So you discount it to the present. It's going to be lower. And then the net worth, which is really important because that's what really drives everything. That's what the intertemporal budget constraint is all about. How much net worth you have is what determines how much consumption you can do.

46:27And you can see it kind of spreads out at the beginning and eventually over time, it's going to decline. As your human capital is declining, as your financial wealth is declining, it makes sense that you expect your net worth to decline over time as well. Over here, we have some economic balance sheets. Did I understand correctly, Paul, that the output is consumption, but asset allocation is an input in the model? No, asset allocation is also an output. Okay, okay. This is just to give you an idea of what an economic balance sheet is. The green areas are in dollars. So there you can see we have your financial wealth and your human capital on the one side.

47:12Then we break it down between asset mix representations of each of these things. Domestic, global stocks, total stocks, bonds, cash, and total. On the other part is the liabilities and net worth. So there you can see liabilities is broken down based upon how much life insurance has an impact on your liabilities. Because if you want to commit to having a certain level of bequest, you also are committing to holding life insurance. So it breaks it down here again the same way. And then what we do right below it is we just do it in percentage terms. If you're thinking about asset allocation, this is saying your financial wealth is 37.5 % in stocks, 50 % in bonds, and 12.5 % in cash.

48:00This is normative. This is telling you what you should be doing. This is telling you where you're at right now. That's why up here it says your current asset allocation. So this is where you are, and this is the direction where things might go. in order to get the actual S allocations, you can't get it from the spreadsheet. You have to use the net worth optimization model. But this is just designed to give you kind of a sense of where you would go on this. You might end up with a more cash-oriented portfolio. Human capital is really big in bonds, 76%. And then the same thing, liabilities and net worth, so it breaks it down.

48:39So these are meant to be kind of indicative. I know this is just an example, but what would drive such a high cash allocation when human capital in this example is so safe? If you have a very cash-like liability, like the life insurance in this case, it's very cash-like because life insurance premiums aren't going to fluctuate with the stock market. You just pay them year in and year out. So that's when this example was leading to a high cash allocation. Which parameters, like if we go back to the inputs, which parameters would have the biggest impact on those optimal allocations? Risk tolerance, for sure.

49:20Because that's going to determine your overall asset allocation. It's going to be driven by that risk tolerance. And so risk tolerance here is set to 55%. What we've done in this example is we've said, okay, then your total asset allocation, ideally we would like to get your S allocation of your net worth to be at 55 % equity. I think that's probably giving me the single most important parameter here in driving this. Now, the other parameters that are going to drive the asset allocation of your financial assets are going to be the things that set the size of human capital, which is your salary, the main parameter, your liabilities, which is the example we just set it here to$50 ,000 a year.

50:06And then these asset allocations that you put here. So the numbers you put here in this part of the spreadsheet, that gets back to the stock broker versus the tenured professor. Super, super interesting. And this spreadsheet is available online. People can use it. Yes. Very, very cool. I'm sure a ton of listeners are going to be spending way too much time in here. You bet they will. Yeah, they will for sure. why is it that the financial services industry which has like some pretty great financial planning software is great in terms of like user experience and they're comprehensive and that they incorporate all kinds of taxes and all that kind of stuff why don't we have this type of software it is a paradox one of the things we have in the book is we actually have a list of all the nobel prize winners who have made an important contribution to life cycle finance.

51:04This includes Milton Friedman, Franco Modigliani, Paul Samuelson, Robert Merton. Their work has been recognized among economists, but why hasn't it worked its way into financial planning practice? I don't know. There is a disconnect between sort of what we know is right, there's so much theory behind it and what we actually do in practice. What role do you see just more generally for financial advisors in life cycle financial decision-making for households? Financial players, I think, play a very important role in coaching and leading their clients towards rational approaches. Obviously, there's now been a lot of literature on behavioral economics and behavioral finance.

51:51We know that real human beings do not behave anything like the agents in economic models. There has been a disconnect between economic theory and practice. So we think that the role that the financial advisor has, the financial advisor has, let's say, a life cycle-based tool that they can use, than it really is to advise their clients to behave in this rational way, in a way to save the clients from themselves. We've always kind of thought about it as not necessarily tell the client what to do, but tell them what a rational person in their situation would do so they can understand the trade-offs of doing something different, which they may still want to do because they are not a perfectly rational agent, but they can at least understand the trade-offs that they're making.

52:41How has your research on this stuff influenced your own finances over time as you've studied this and modeled it? I have to admit that I haven't actually run a life cycle model, but I'm in good company. Harry Markowitz, right, the father of modern portfolio theory, was once asked, how do you do your asset allocation? And he said, his answer was, well, I know I should be running an optimizer, but what I actually do is I do 50 % stocks and 50 % bonds. I'm kind of in that school, yeah. I know the theory and everything, but I retired a little over three years ago now, and I haven't changed my consumption patterns when I retired.

53:23So I think I am on a smooth consumption path. The other thing, and this is not directly related to this research, that is the value of indexing. I mentioned earlier that an active manager may or may not add alpha or additional return to your portfolio, but they're certainly going to add risk. I do some indexing as well, and I think that's pretty consistent with my approach. In some ways, I do things at the asset class level more than I do with any individual product. We think about it the same way and spend a lot of time on this podcast talking about the benefits of indexing. And we did talk a little bit about factor investing and tilting toward sources of higher expected returns within an asset class.

54:09But broadly speaking, we would be in agreement with you. There's a whole other line of research that I've been doing together with Tom Zurek, the co-author in this book, and also Professor Roger Ibbotson at Yale, who Tom and I used to work for at one time, was called Ibbotson Associates. It was bought out by Morningstar in 2006. But we've been working with Professor Ibbotson on these very issues. So we have another book. Also, it's published by the CFA Institute Research Foundation called Popularity, A Bridge Between Classical and Behavioral Finance. And so there in that book, you'll find our whole theory about why there are these factor premiums, basically.

54:50And we also did an article called Taming the Factor Zoo, I think in the Journal of Portfolio management where we talk about how we even identify a factor. It can't just be that it pops out of the data. It's got to also be backed up by economic theory. You have to come up with an economic theory about why a particular factor should pay off. And then there's another paper we did in the Journal of Investment Management, which I'm proud to say we received the Harry M. Markowitz Award called the CAPM, APT, and the PAPM. The PAPM comes from our popularity book, the Popularity Asset Pricing Model. So that goes more into where we think factors should come from.

55:32We think it comes from preferences. And we did incorporate these preferences in the third part of the book, the grandchild model, where we take into account for every fund, we have it exposed to certain characteristics. And then we combine that with what that investor's preferences might be regarding those characteristics. That would lead to certain factors paying off. Very interesting. We actually talked about your popularity book in episode 174, which was back in November 2021. We did an episode on whether a good company and kind of air quotes is a good investment and it relates directly to your book.

56:14So we talked a whole bunch about what you guys talk about in the book and the research findings in there as well. Who did you interview for that? Nobody. We alternate between having a guest and doing an episode where Cameron and I do a deep dive on a topic. So that episode was a deep dive where we were just talking about that general idea of or asking the question of whether a good company is a good investment. And yeah, so your book was an obvious source for that discussion. Our final question for you, Paul, how do you define success in your life? Well, let me talk about it maybe first and just in terms of my career, which is I think I've made some positive contributions here and there.

56:48And doing things with rigor and integrity, I think is important. If you look at all my work, be it this book on life cycle finance, or the book on popularity, or my first book called Frontiers of Modern Ass Allocation, published in 2012 by Wiley, everything I write in there, everything has to follow from like first principles. I was trained in economics where your conclusions have to be based upon, you know, the first principles. I've tried to apply that principle to everything I've done professionally. Incredible. We very much appreciate the work that you've done in this book and your other work and research.

57:31This has been a fantastic conversation. I know listeners will get a lot from it and even more so because they can take what they've heard and bang around in your Excel spreadsheet to see things for themselves. Yeah, it's great to have you on. Great to meet you, Paul. Thank you. Thank you. Good to be here.

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