Friday, June 29, 2012

Paula Hogan’s “Financial Planning: A Look from the Outside In”

Paula Hogan’s article in the June 2012 Journal of Financial Planning is Financial Planning: A Look from the Outside In. It picks up where she left off five years ago with her May 2007 JFP article, Life-Cycle Investing is Rolling Our Way. An objective of both articles is to try to convince the financial planning community to pay closer attention to the theory of life-cycle saving and investing connected most closely with economists Paul Samuelson and Robert Merton, and later with Zvi Bodie as well. She admonishes the CFP Board for not including life-cycle finance in the CFP curriculum.

As a side note, I am curriculum director for the Retirement Management Analyst designation, which is very focused on building practical applications from life-cycle finance concepts. I will be one of the speakers, joining luminaries including Zvi Bodie and Laurence Kotlikoff, at the Salem State University boot camp for the RMA in August, and more information about that is available at the end of this post.

Hogan’s contribution in this new article is to synthesize key concepts from the lifecycle finance theory of academic economics with the financial planning movement called “life planning.”

Briefly, life planning is “the process that facilitates the discovery and achievement of one’s lifetime goals.” As it involves elements of psychology and counseling, discussing it in detail is a bit out of my element. Hogan’s argument is that lifecycle finance provides a rigorous theory to justify the concepts of life planning, and that the role of financial planners must increasingly be to facilitate clients with a “lifelong process of integrating personal values with the management of both human and financial capital for the betterment of self and community.”

I think that the key to integrating the two concepts is that both make human capital as a centrally important focus. Human capital is the present value of your lifetime earnings. This is a central point, because it suggests that financial planners should worry much more about getting clients on the career path which best meets all of their goals related to satisfying work, life-leisure balance, high salary, recharging one’s batteries in order to be more productive overall, the ability to do things that provide value and meaning to life, etc. 

It is about managing human capital. This includes having proper disability and life insurance and also something called “career asset management” which I think focuses on strategies to build ones career and to also have contingency plans for changing careers should the need arise. Investing in education, training, and so forth, should be evaluated in a comprehensive manner in terms of lifetime monetary and psychic costs and benefits.

As such, managing the investment portfolio is only of secondary importance. And portfolio management must be done in a way that complements human capital (this is the normal lesson of figuring out whether your human capital is a stock or a bond and then reacting accordingly).

Secondly, people care most about their life-time standard of living, not portfolio wealth. I agree wholeheartedly with this. It’s been a common theme here. Are there really still financial planners who focus solely on “The Number”? They should stop doing that. For one thing, the number varies with interest rates. For another, it varies with market valuation levels. Wealth is also abstract in the sense that what looks like a lot of wealth may be much less impressive when you start to think about the annual spending power it can potentially support.

In order to shift the focus to lifetime living standards, life-cycle finance focuses on smoothing consumption, which consists of shifting consumption from times of plenty to times of scarcity. This includes saving for retirement, purchasing appropriate insurance, building downside protection and protecting against longevity and inflation risk.

Life-cycle finance also focuses on matching investments to goals. Risk capacity becomes more important than risk tolerance. This means, when working to meet essential goals for which failure would be catastrophic, you have little room to take risks (defined as accepting greater volatility in an attempt to obtain higher returns) and should focus on matching safe investments (such as TIPS) to the goals. It doesn’t matter if you feel like an aggressive investor. Relying on high stock market returns is a hope, not a plan. Your aggressiveness should only manifest after you have the basics covered and are then working to meet more discretionary goals.

I’m not sure if I still fully accept all of the last paragraph myself. I think this may be a natural dividing point where people may have fundamental disagreements. The alternative to the above is to use a well-diversified portfolio and to focus on the probabilities of meeting goals. Since using safe investments is quite expensive in the current low interest rate environment, a more diversified portfolio may give a higher probability of helping one to reach one’s desired lifestyle, even though it will also increase the probability that the basic needs are not met. But people with enough flexibility may be willing to take their chances on this. Though he was talking about something different at the time, I think a quote from Harold Evensky applies here: “Advising clients to radically reduce their standard of living in order to protect against the unlikely probability of three standard deviation events is inappropriate.”

More generally, there are other approaches to flooring besides the goals-based approach which Hogan describes. My most recent Advisor Perspectives column provided an attempt to clarify some of these differences which came about in discussions with the RMA Curriculum Advisory Board. Of course, I must include, the alternative versions of flooring do assume that you have sufficient assets to build a floor which meets basic needs, and Hogan is specifically discussing the case where you are underfunded with your attempts to meet basic goals. That does complicate things. Unfortunately, this underfunding case describes all together too many Americans now approaching retirement. Should these folks use what they have to buy an inflation-adjusted immediate annuity, or should they take their chances with a diversified portfolio? There is no generalized agreement on the answer to this question.

One more point which Hogan makes, and which I think Zvi Bodie has been making for at least 10 years, is that we are on the cusp of a new era of retail financial products based on derivatives, which will allow for dividing up more risks and spreading them to who is best equipped to bear them. Dealing with financial derivatives is now rather standard for corporations, but it is still rather limited for households. It seems that this retail revolution has been slower coming than expected, but that doesn’t mean it won’t still happen. 

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Add Sizzle to your Retirement Income Business by Earning the Retirement Management Analyst  Designation this Summer!

Coming in August is the Salem State University Intensive Seminar to prepare for the Retirement Management Analyst (RMA) Designation.

Summer is a perfect time to earn this advanced education and heat up your retirement income business by attending this 5-day in-class intensive seminar from Monday through Friday, August 13-17, 2012.

The seminar costs just $1,575 including refreshments and lunch. On campus lodging is available for a low additional fee. To sign up for the summer seminar, contact Salem State University, Professional and Community Enrichment Programs or go to
Key faculty and guest instructors include:
  • Francois Gadenne, Chairman and Executive Director, Retirement Income Industry Association
  • Stephen Mitchell, Director, Advisor Education, Retirement Income Industry Association 
  • Dana Anspach, CFP®, RMA, Founder, Sensible Money, LLC and the Guide to MoneyOver55
  • Zvi Bodie, the Norman and Adele Barron Professor of Management, Boston University.
  • Lawrence Kotlikoff, PhD, Professor of Economics, Boston University
  • Dan McGrath, Director of Healthcare Funding Strategies, at HVS Financial
  • Alain Valles, Founder and President, Direct Finance Corporation
  • Wade Pfau, Associate Professor at GRIPS and Curriculum Director for the RMA Designation


  1. When discussing life-cycle saving and investing, let's not neglect the contributions of Franco Modigliani. :-)

  2. Re the cusp of a new era of financial derivatives, it seems rather that we are entering an era of disillusion with the financial industry, in which no one will want to buy products from a tainted industry, especially when those products are derivatives, which most ordinary folks (and probably most advisors)will not understand and be able to assess on their own. Until the financial industry undergoes a radical shift into a more ethical culture, I would hardly start advising my friends and family to buy into derivative products (the old advice, if you don't understand it, don't buy it, would apply). What value there might be in derivative-based products is negated by the high likelihood that people will be taken advantage of.

  3. I completely agree with the CanadianInvestor. I actually emailed Hogan directly about this a few months ago but never heard back. Even worse is that Bodie, in "Worry Free Investing" specifically recommends some structured products by name. That book was written in 2003. But when I read the book recently and googled those products the first several hits were about class action lawsuits against the issuer. Oops.

    My basic takeaway about life-cycle investing is that it's good in theory but (currently) bad in practice.

    I'd like to see someone trustworthy like Vanguard start issuing market-linked cds, structured products, etc. These products all sound very simple to make. I'm really surprised that no one seems to be attempting to dominate the retail market for them by focusing on transparency and cost.

  4. Thanks for the comments.

    Franco Modigliani, Frank Ramsey, Irving Fisher, & Milton Friedman all deserve lots of credit too!

    I understand your points about financial derivatives. That is probably the big stumbling block. Transparency and cost is so important, but the more complicated the product, the easier it becomes to hide various fees.

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  7. 'Should these folks use what they have to buy an inflation-adjusted immediate annuity, or should they take their chances with a diversified portfolio? There is no generalized agreement on the answer to this question.'
    In my work with Manish Malhorta of, we have looked at this issue as well. I built a high yielding portfolio of 13 stocks, mutual funds and an ETF. This portfolio is well diversified and includes domestic and international stocks as well as a HY bond position. The dividends are largely inflation adjusting and represent roughly a 5.2% to 6% dividend stream, currently. Measured against the R3000 index, the portfolio carries a three year .46 beta.
    I believe that one can provide inflation protection, a high level of income and lower risk to the market without necessarily resorting to the typical allocations that might reflect this desire, while at the same time providing a great deal of flexiblity in managing ongoing risk, a la the 3 STD events we all fear. The flexibility of a high dividend low beta portfolio allows for income distribution without triggering share selling in the portfolio to generate this income. It allows for a welcome cash cushion in down markets and it can be opportunisitically invested when market conditions permit.
    I think that by looking outside the box of the typical allocations that would be considered in constructing a porfolio based on lifecycle planning, one can provide income funding that would be reflective of the various stages that clients pass through in life. We can do this without losing flexibilty through the use of annuities or TIPS, although clearly these products can enhance the planning options when combined with a high yielding stock portfolio.

    1. Mitchell, thanks for sharing. I'm always glad to hear from planners who are actively searching for better solutions. What you are doing sounds quite worthwhile and worthy of investigation. I'm still mostly at the level of working with the standard indices, but there are other approaches as you describe. Thanks again.

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