Conventional vs. Economics-Based Financial Planning

MaxiFi is the only Economics-Based financial planning software generally available to households and pros. But what is economics-based financial planning? And how does it differ from the "conventional" financial planning approach that all other tools use?

Conventional planning begins with setting an annual retirement spending goal. The goal is typically set at 80% of your pre-retirement income. Alternatively, the retirement-spending target is based on your desires or your current spending.

An 80 percent replacement rate is generally far too high. As for our desires, they are the definition of unaffordable. Meeting them is why most working households are spending far too much. Thus, using current spending to target future spending extends financially dangerous behavior.

Once “your” target is set, conventional planning runs Monte Carlo simulations to determine if “your” plan is safe. Specifically, your initial wealth and annual pre-retirement saving are accumulated and your post-retirement targeted spending is decumulated based on randomly-drawn annual investment returns.

Your probability of plan success is measured as the share of these simulations that achieve positive terminal wealth. The industry views an 80 percent or higher plan-survival rate as successful/safe. But having a one-in-five chance of running out of money in retirement doesn’t meet a reasonable fiduciary standard!

If, as is highly likely, you’re saving too little, targeting your retirement spending too high, and investing conservatively, “your” plan will fail. I.e., you’ll run out of money more than 20 percent of the time.

Once your plan is pronounced a failure, you’re not told to save more and spend less. Instead, you’re advised to invest in higher yielding (codeword for riskier) securities or are connected with an adviser to do so. Yes, more aggressive investing raises the probability of plan success. But it also raises the generally undisclosed chance of running out of money earlier in retirement, i.e., spending more of your retirement in poverty.

In sum, conventional planning reinforces two key financial problems – saving too little when young and investing in too risky a manner.

Worse yet, conventional planning puts your pre-retirement saving and post-retirement spending on autopilot. Thus, if your investments go south, you’re told to continue spending your targeted amount. This exacerbates what’s called sequence of return risk and is part and parcel of convincing you that riskier investing, which routinely comes with asset management fees, is the answer.

Two final concerns. First, the assumption that neither saving nor investment change through time as you do well or poorly on the market – which will, in fact, happen -- means each conventional Monte Carlo simulation is calculating the wrong path of taxes and thus the wrong probability of plan “success.” Second, research shows that conventional Monte Carlo analysis is highly sensitive to the return distributions embedded in the software tool being run.

Economics-based planning is reality-based planning, not pie-in-the-sky, "What’s Your Spending Goal?” planning. Economics-based planning recognizes you can only spend what you can afford and not a penny more.

MaxiFi Planner is the only tool that implements economics-based financial planning. It does lifetime budgeting, determining what you can sustainably spend given your current and future income as well as cashflow constraints. Economists call this consumption smoothing.

MaxiFi considers housing, taxes, and other “must spends.” It then generates an internally consistent annual discretionary spending plan and an associated saving plan. The plan maintains your family’s living standard (discretionary spending) through time. To repeat, this is realistic planning, not wishful thinking.

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