Economists versus(?) financial planners, part 1: saving, spending, and mortgages

Back in October (of 2022, if you're reading this From The Future), the Freakonomics podcast released an episode on financial planning -- specifically, "Are Personal Finance Gurus Giving You Bad Advice?" In this episode, we hear what Yale economist Dr. James Choi has to say about various personal finance topics.

(Why not ask a financial planner? Because Freakonomics isn't a show about financial planning; it's a show about economics, so of course they're going to talk to an economist!)

The episode is worth a listen, or a readthrough of the transcript; economists are no dummies! And if you're curious as to what a financial planner's opinion on an economist's opinion is, well...this is the article for you!

Spoiler: if you're looking for a fight between me and the Yale professor they interview, you've come to the wrong place. Sure, there were parts that had me going, "Show me your analysis; I'm not convinced." But there were also parts of the podcast that had me going, "Yes! Exactly!" For example, the discussion on "consumption smoothing".

Speaking of which...

Saving v. spending: an economist's view

The popular advice on saving is "save as much as you possibly can, so that you have a ton of money in retirement." (Popular financial author/speaker Dave Ramsey sums it up as "if you will live like no one else, later you can live like no one else." Catchy, no?)

Dr. Choi points out that economists generally recommend exactly the opposite: instead of living like a pauper now so that you can be a king later, strive to maintain a more or less consistent standard of living throughout your life. Why? He bases his answer on the "diminishing returns" phenomenon that we probably all learned in high school economics: the fifth slice of pizza (my teacher used donuts, which works just as well) is a lot less satisfying than the first, so why eat zero slices of pizza today so you can eat ten tomorrow?

In order to avoid this, he says, economists suggest that you should mostly work to smooth your consumption, saving less in your early years and more in your later years (assuming that your earning power goes up over that time). And he also suggests that you should account for any unique opportunities and take advantage of them in order to maximize your joy -- for example, potentially spending tens of thousands of dollars one year on a blowout wedding, if that brings you joy.

My take? I agree, 100%. I work a lot with engineers, and we love just watching the numbers go up, so it's easy for us to be convinced to save more earlier in order to take more advantage of the miracle of compound interest. So we often end up saving a lot and then never spending our savings.

But where does that leave you? Unchecked, it leaves you sitting on a pile of money that you never use before you eventually kick the bucket. In my opinion, unless you have very specific legacy goals, you may as well have just set that money on fire. What was the point of saving all that money, of doing all that optimization, if you were never going to spend it? Why have so much money that you could buy ten pieces of pizza, if you were only ever going to eat two in the first place?

So when we run a financial plan at Seaborn, we assume a mostly-fixed standard of living (modulo some interesting variations where appropriate, like weddings!), stretching from now through retirement and death. If the Monte Carlo success rate is above our "in danger of dying rich" threshold, we then modify the plan -- perhaps increasing spending assumptions, or moving up the retirement age -- until it's just below said threshold. Then comes the fun part: we work with the client to figure out how they're going to increase their spending, or how they're going to retire without getting bored!

So in this case, we 100% agree with the economists: we focus on the standard of living first, and then create a savings plan based around that. Is this super common with financial planners? Not really -- many espouse a "save as much as you reasonably can, because you never know what's going to happen" approach -- but we sleep better at night knowing that we're helping our clients set as little of their money on fire as possible, as it were.

Mortgages and the fixed-rate v. ARM debate

Now, if you were eagerly awaiting a topic where Dr. Choi and I differ, well -- wait no longer! In the next section of the podcast, Dr. Choi makes another controversial recommendation: people should take out adjustable-rate mortgages rather than the traditional fixed-rate 30-year term mortgages, no matter how long they're planning to stay in the home!

(Quick primer: adjustable-rate mortgages fluctuate with current interest rates, while fixed-rate mortgages have, well, a fixed rate. ARM's generally have lower rates than their fixed-rate counterparts, to compensate for the risk that interest rates rise in the future.)

I actually agree with his fundamental argument: while ARM's seem risky on the surface, the volatility is actually only in terms of the nominal rate. Once you adjust for inflation, however, the volatility goes away, because interest rates -- and hence, ARM's -- track inflation quite well. As of this writing, a classic example is fresh in everyone's minds: inflation went through the roof in 2022, and central banks raised interest rates to compensate!

The argument Choi makes is that in addition to ARM's having a lower interest rate, they can also more easily take advantage of falling inflation; as inflation decreases, your ARM payment will also decrease, whereas a fixed-rate mortgage won't, and thus is risky.

But here's where I disagree: a fixed-rate mortgage can, in fact, decrease with inflation. It just requires an annoying amount of work, in the form of a refinance when interest rates are low. Once that work is done, though, you are nicely hedged against rising inflation, while still being able to take advantage of falling inflation by refinancing again, should the circumstances warrant.

Now, granted, refinancing is rarely free, so it often only makes sense to do so if interest rates have fallen significantly (generally 1% or more). Also, you have to be paying attention to interest rates in the first place -- or have a financial planner who keeps an eye on such things on your behalf!

Still, the point remains the same: fixed-rate mortgages allow you to take advantage of falling inflation and ignore rising inflation. To think about it another way: the difference between the interest rate on ARM's and their contemporary fixed-rate mortgages will rarely make or break a financial plan. The flip side is that if interest rates rise, the difference between ARM's and the mortgage that was purchased while interest rates were low could absolutely have a huge impact on your financial plan! Low risk, high potential reward -- that sounds a like a good bet to make.

(Now, Dr. Choi doesn't mention refinancing one way or the other, so it could be that there's an argument he didn't have time to present; I just wish he'd mentioned a specific paper by name, so I could look it up!)

Thoughts so far

I love having economists weigh in on the personal finance debate, because they're able to take a step back and look at things in the abstract. What does the data say? What does the theory say? Contrast this with many personal finance authors, who go for what's intuitive, what they've seen play out well.

Both are, I think, valuable; it's easy for economists to ignore pesky details (like the ability to refinance a mortgage), but it's just as easy for personal finance authors to ignore abstract concepts (like long-term diminishing returns).

As long as we understand why the recommendations are made, it's all to our benefit; we can understand the pros and cons of each approach, then make the choice that best reflects our mental framework, risk tolerance, personal situation, etc.

That's it for now! Next time, we'll talk more about the psychological aspects of personal finance, with an appearance on the podcast episode from one of my favorite authors, Morgan Housel!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.