Software offers a different approach to financial planning.
The front page of the ESPlanner Web site boldly
proclaims: "Traditional financial planning asks households to do all
the hard work. It makes them set their own saving and life insurance
targets. This puts them at risk. If the targets are set too low,
they'll undersave and underinsure. If the targets are set too high,
they'll oversave and overinsure. Even small targeting mistakes can lead
to huge mistakes in saving and insurance recommendations." Let me put
it to you in a slightly different way: What they are really saying is
that virtually every financial advisor reading this article is planning
for their clients incorrectly.
Before you write off the claim as the ranting of some lunatics, however, please consider the source: ESPlanner was developed by Professor Laurence J. Kotlikoff, chairman of the Department of Economics at Boston University, and Dr. Jagadeesh Gokhale, a senior fellow at the Cato Institute, who served for many years as senior academic advisor to the Federal Reserve Bank of Cleveland. The two economists are leading authorities on the economics of consumption, saving, insurance, portfolio choice and fiscal policy. ESPlanner originally was developed as a scenario generator for academic research. At some point, the developers decided to test its commercial appeal, first targeting individuals and later advisors.
Today, there are two versions of ESPlanner: ESPlanner and ESPlannerPlus. Each version is available as an individual edition (one planning file only) and as a financial planner edition (multiple planning files). The Plus version of the software includes a Monte Carlo simulation module. This module illustrates how the investment portfolio influences the variability of living standards in future years.
ESPlanner is Excel based. In the past, I've often found programs of this class to be uncomfortable to deal with, but ESPlanner is an exception. A navigation bar, well-designed data entry screens and a context-sensitive pop-up guide allow new users to familiarize themselves with the program in a reasonable period of time.
One appealing aspect of the program is that it doesn't require a tremendous amount of data entry to begin the planning process; hence plans can be produced economically. ESPlanner lists 18 principal data requirements: pay stubs, planned retirement age, projected earnings, projected "special" expenses (college, weddings, boat, world travel, etc.), other cash inflows (bonus, inheritance, etc.), market value of taxable assets, value of retirement account(s), value of emergency fund, rental expenses (if applicable), housing expenses (mortgage, taxes, insurance), funeral expenses and bequests, value of life insurance policies, amount you expect to add or subtract to taxable assets this year (used to calculate actual savings), contributions to retirement accounts, some information regarding defined benefit plans and annuities, and Social Security earnings. You also need the clients' dates of birth. The Plus edition requires some additional portfolio information in order to run the Monte Carlo simulations.
The above may sound like a lot of information, but it isn't. When I tried to enter data for an imaginary upper-middle-class family, I found the process took significantly less time than many competitors require.
Upon completion of the data entry process, you can run various reports. The basic report set offers recommended levels of consumption (the level amount you can comfortably afford to spend throughout your life), a recommended savings level, and a recommended insurance level. In addition, the Plus edition will perform a Monte Carlo analysis (based upon 500 iterations) of the growth in asset values of the taxable and tax-deferred assets.
While the "base" reports are interesting, the comparison reports are the real "meat" of the program. These reports allow the user to generate multiple scenarios and illustrate the outcomes in terms of lifetime consumption. For example, a client might ask you, "What would happen if I retire at age 60 instead of age 65?" With a traditional financial planning program, you might solve for the "nest egg" at retirement ("You'll only have $1,000,000 to live on the rest of your life."), or you might solve for when the money will run out (you'll run out of money at age 91 instead of age 95). ESPlanner frames the answer differently. It will tell you, "If you retire at age 60, here is how much you can afford to spend each year for the rest of your life; if you retire at age 65, you can spend this much."
You can also easily compare the impact of various investment choices and the placement of investments. For example, if a client needs to save $1,000 more per year, where should it go? You could run three scenarios (taxable, tax deferred and Roth IRA) in a couple of minutes, and illustrate the impact on sustainable consumption.
Of the three primary reports, the most interesting one is the life insurance report. According to Jim Pinney, a fee-only planner with Pinney & Scofield Inc. in Cambridge, Mass., the program handles life insurance differently than other financial planning programs. "This program insures the adult equivalent standard of living. It solves for the amount of insurance that will replace the lost income needed to support the recommended consumption level."
As Pinney points out, the program insures contingent income streams in a clever way. "Let's say that a husband expects a substantial inheritance in 10 years," Pinney says. "The couple's lifetime consumption will go up (the program allows borrowing to cover temporary shortfalls; maximum limits can be set). If the husband dies, the wife might not get the inheritance, so there will be a greater consumption shortfall, and the program will recommend enough insurance to provide the higher recommended level of consumption for the surviving spouse.
The program uses intelligent shortcuts to determine changing consumption levels. For example, if a single person lives in a house, the expense level could be set at 100. If the person marries, consumption probably won't double, because two can usually live under one roof cheaper than one, so the spouse gets an index of, say, 60. A couple might have an index of 160, but if the spouse dies, the index will be decreased to 100. Children work the same way. It is assumed that a child, from birth to age 19, adds 70 points to the standard of living index (these numbers can be changed by the user).
Currently, ESPlanner has a small but very enthusiastic following. Rick Miller, a financial planner in Cambridge who holds a Ph.D. in economics from the University of Chicago, says, "This is the one piece of software that tells clients how much they can spend." According to Miller, "Their dynamic, stochastic financial planning model is, theoretically, the right way to do it." Pinney is another fan: "I find it to be fast and accurate," he says.
I'm not quite as enthusiastic, although certain aspects of the program I appreciate. First of all, as ESPlanner fan Pinney readily admits, this program is not for everyone. "It is geared to the middle and upper-middle class," he says. I'd agree. While you can "budget" for bequests, there is no estate planning capability. Since it lacks the ability to incorporate disability insurance, long-term care insurance or employee stock options and a host of other factors into the analysis, one could argue that it is not a "comprehensive" financial planning tool.
There are also a few minor bugs that need fixing. For example, you had better enter your client's names and dates of birth correctly the first time; you cannot change them. The developers are a little behind with some of their tax table updates, but this should be rectified soon.
With all due respect to Professor Kotlikoff and his colleagues, I think their Web site overstates their case and understates the effectiveness of financial planning as it is currently practiced by the professionals I know. Bill Bengen, a financial planner in El Cajon, Calif., and the author of a number of groundbreaking studies of sustainable portfolio withdrawal rates, put it much more eloquently than I can:
"Although ESPlanner (ESP) appears to be a decent piece of software, it does not break much new ground, as claimed by the authors. Much other financial planning software currently available, such as MoneyGuidePro (MGP), which I use, seems to perform virtually all the tasks claimed for ESP. In addition, MGP is Web-based, which puts it one very important leg up on ESP. "
I also believe that the criticism of financial advisors by ESP authors, for allowing clients to set saving and spending goals by themselves, is a case of setting up a straw man, then knocking him down. I don't know any competent advisor who would not recommend that clients alter their spending goals for retirement if they appeared to be unrealistic.
I think a more serious problem is that the program may instill in some advisors what Harold Evensky termed "a false sense of accuracy." ESPlanner's literature makes much of its ability to correctly calculate the real impact of income taxes and its ability to optimize Social Security benefits accurately. That may leave do-it-yourselfers who purchase the individual version and some of our less sophisticated colleagues with the impression that the program can do more than it actually can. Or, as Bengen puts it:
"ESP claims a certain degree of precision in its computations not available elsewhere. Because of all the uncertainties inherent in the future, I believe financial planning software should focus, to paraphrase Warren Buffet, on being approximately right rather than run the risk of being precisely wrong. We should not give our clients the impression that financial planning is a science. That raises expectations we will be unable to meet."
On the other hand, there are some things that I really like about ESPlanner. One of its strong suits is its unique, consumption-based approach to life insurance planning. Apparently, I'm not the only one who found this feature appealing. The ESPlanner users I talked to were particularly fond of this feature.
The alternative approach to financial planning is not without appeal, particularly when it is used for comparative purposes. As software developer and financial planner Gobind Daryanani, CFP, Ph.D., told me, "I don't care about showing the end terminal wealth. It is bound to be wrong. What's important is using financial planning software for comparison purposes, to chose among alternative courses of action." ESPlanner does this well, and it does it from a different perspective than other programs do; there is value to that."
So what's the bottom line here? Frankly, I'm not sure. I enthusiastically welcome any attempt to design better financial planning tools for advisors, and from a conceptual point of view, a stochastic, dynamic model is better than one that is either static or deterministic. The program's approach to life insurance needs analysis is interesting, and worthy of further discussion.
In practice though, I'm not yet convinced that this particular program produces "better" financial plans. Hopefully, bringing this program to the attention of a wider audience will spark further debate about its merits, as well as the future course of financial planning software. If that happens, we all stand to benefit.
ESPlanner is compatible with Windows 95, 98, NT, 2000, and XP. Microsoft Word and Excel are also required. The program will function on any modern vintage computer, however more powerful CPUs and more RAM will yield speedier results, especially when performing Monte Carlo simulations.
James Pinney is interested in sharing his ESPlanner experiences with other professionals. He has developed a number of his own report templates that he uses for client presentations, and he has graciously offered to share them with Financial Advisor subscribers. If you are interested in discussing the program or receiving the templates, please contact Pinney directly at firstname.lastname@example.org.
Joel P. Bruckenstein, publisher of
Virtual Office News, www.virtualofficenews.com. and an expert in applied technology for financial services professionals, can be contacted at email@example.com.