University of Virginia Darden School of Business research shows new, more effective ways to plan for retirement.
Every day, financial planners help future retirees determine how much they'll spend or "consume" each year of their lifetime. The answer lets individuals know how much they'll need to save to live comfortably. However, making plans without knowing how long you will live is a financial challenge. As the saying goes, "You can't take it with you when you die." At the same time, individuals do not want to outlive their retirement savings.
Darden Professors Samuel E. Bodily, John Tyler Professor of Business Administration, and Assistant Professor Casey Lichtendahl discussed what they believe to be a more effective preference model for the financial-planning problem in their award-winning research paper, "Preferences for Consumption Streams: Scale Invariance, Correlation Aversion and Delay Aversion Under Mortality Risk."
The professors demonstrate that people should put their money where their health is.
"People tend to 'under plan,'" said Bodily. "They plan to spend less at 65 years of age and spend more money when they are in their 80s. With this type of spending delay, individuals risk not getting to spend as much as they might like during their lifetimes."
To better determine consumption habits, a small but growing number of financial planners offer computer-based forecasting tools. The tools ask individuals to enter information about financial obligations, savings and assets. These "financial planning calculators" generate reports that guide individuals and their planners as they choose the best approach for growing retirement savings based on consumption during each phase of a retiree's life.
Bodily and Lichtendahl favor this approach, but identify one pitfall: The common financial model, which takes additive preferences into account, fails to address dependencies on uncertainties. It doesn't distinguish between situations in which consumption is all bad or all good versus situations in which there are some bad and some good years. Instead, the researchers developed the multiplicative-expo power utility (MEP), which accounts for risks and uncertainties. Using MEP can help financial planners better forecast their clients' retirement spending needs.
Past lab experiments that studied consumption preferences showed that most people are "correlation averse," meaning they prefer to have a mixture of bad and good years rather than all bad or all good years. One positive effect of using MEP is that it suggests that retirees spend more in their early retirement years when they are more likely to be healthy and able to consume more rather than later.
"We're taking raw preferences of individuals and using the information to make decisions about spending," said Lichtendahl. "This model has important implications for how planners and analysts advise individuals planning for retirement."
"With MEP, you can solve dynamic problems because you can take them apart in time," Bodily added. "The MEP form is general and can also help with decisions such as career choices, investment choices and insurance planning."
Earlier in the fall, they were chosen as finalists for the 2012 Decision Analysis Publication Award. The prize recognizes the best 2010 publication in "decision analysis, broadly defined." The members of the 2012 Publication Award Committee chose their work because it offered a significant impact on decision-making and business practice. Their research was published in the journal Operations Research. Bodily and Lichtendahl were recognized at the conference of the Institute for Operations Research and the Management Sciences for receiving the award.
Last month, Bodily and Lichtendahl won the "Best Paper" Decision Analysis Special Recognition Award for their December 2012 paper in Decision Analysis on "Multiplicative Utilities for Health and Consumption." This paper builds upon the use of multiplicative utilities such as MEP to connect consumption habits with health status and future health considerations.
Bodily researches decision and risk analysis, strategy modeling and analysis, forecasting and lifetime consumption, and investment planning. He has written several books, a wide variety of journal articles in publications including Operations Research and Harvard Business Review and more than 120 cases and technical notes on quantitative analytics.
Lichtendahl teaches Quantitative Analysis courses in Darden's MBA program. His research focuses on eliciting, evaluating and combining probability forecasts for use in corporate and governmental decision-making situations. His other research interests include modeling consumption preferences for use in personal financial decisions.
In addition to advancing knowledge in the area of decision analysis and modeling, Bodily and Lichtendahl hope to modernize the way financial planners and wealth managers help individuals shape the quality of their older adult lives through more effective planning for retirement.
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