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Financial Planner Blog

Economic Benefits from Financial Planning, Part II

By Joel Redmond, CFP 

In a previous article, we looked at the potential impact of financial planning on a nation’s GDP. Here are a few follow-up questions: What impact does financial planning have on the total cash flows of an entire nation? How is this impact divided between the component cash flows of GDP? How does a change in one part of GDP impact the other parts?

These are ambitious subjects for a 3-volume book series, let alone a blog post – but maybe we can still find something useful in doing some cursory analysis.

We said in the last article on this topic that GDP is made up of four components. They are:

C – consumption

I – investment

G – government spending

X – M – exports minus imports.

So we get: GDP = C + I + G + (X – M).

In the last article, we looked at a financial planner who helped her client create a savings program that made the client $100,000 wealthier at retirement than a client without such a program. Now we have to ask: did we actually create $100,000 of GDP? Or did we just move $100,000 from one component of GDP to another? The answer to this question is important: it validates or disproves the assertion that financial planning makes a genuine contribution to the net worth of a nation.

How can we possibly prove such a point? Well, we can use time value of money (TVM) formulas. Let’s set a few TVM variables for the client who initiated the savings program. Let’s say:

N = number of years between the beginning of savings and retirement = 20

I = interest rate on the investments = 4.85%

PMT = $3,072.52*

PV = present value of the $100,000 = 0

FV = future value of the $100,000 = $100,000

We can see from this that the client saved $3,072.52 each year for twenty years. The critical question is: what does this money really represent as it pertains to GDP? Let’s look at this in terms of only C, I, and G.**

C – this is consumption. According to the Economics Web Institute***, consumption can broadly be divided into ten areas. They are:

1)      Food

2)      Clothing

3)      Housing

4)      Energy

5)      Health

6)      Transportation

7)      Furniture/appliances

8)      Communications

9)      Education/culture

10)    Entertainment

I – this is investment. A working paper from NYU’s Stern School of Business tells us that it’s made up of two major components****:

1)      Nonresidential investment. This means essentially business purchases of plant and equipment (the paper intimates that these are long-term assets).

2)      Residential investment. These are single-family and multi-family homes.

This paper – if you look at it, you’ll see that the well-known economist Nouriel Roubini’s name is connected with it – says that these two components make up about 14% of GDP in the US.

G – this is government spending. It is probably the easiest to recognize of the three components: it’s anything the President and Congress decide to toss into the shopping cart. This can be anything from Stealth Bombers to Medicaid payments to the fireworks for the White House 4th of July picnic. The obvious and less-than-well-beloved implication to the individual investor here is taxes.

OK. So now we understand the three components of GDP we’re looking at in more detail. But what about the $3,072.52? First, let’s assume that the client saved it in a tax-qualified account, like an IRA. Let’s make a few other assumptions:

  • Her tax bracket is 30%
  • She spends 25% of her after-tax pay on her mortgage
  • The multiplier effect of consumption spending is 1.3*****

With these numbers, let’s do the calculation.

A savings of $3,072.52 results in a loss of after-tax income of $3,072.52 (1 – 30%) = $2,150.76****** – this is a loss to C for the client. The multiplier effect means that 1.3 ($2,150.76) = $2,795.99 is lost to the economy. So we can perhaps posit that

$2,795.99

is the consumption cost to the economy’s GDP for the client’s decision to save.

What about investment? Well, according to the definition above, only this client’s mortgage payment would have really counted towards investment. So we get:

25% ($2,150.76) =

$537.69 lost to investment

$537.69 is the investment cost to the economy’s GDP for the client’s decision to save.*******

And tax? We know that the government loses the 30% tax on the client’s savings for now. This sum represents:

$3,072.52 (30%) = $921.76

So $921.76 is the government cost to the economy’s GDP for the client’s decision to save.

What happens when we add these? We get:

$2,795.99 + $537.9 + $921.76 = $4,255.44 per year in direct losses to GDP.

If we multiply this by the savings period (not taking TVM into account), we get

20 x ($4,255.44) = $85,108.80.

Well, problem solved, right? Financial planning is a drain to GDP. Go tell it on the mountain: spending is the new saving!

Wait; not so fast. What is GDP? According to CFA Institute, GDP is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners buy.********

The solution to this conundrum is deceptively simple: a higher GDP just means people are spending more. It doesn’t mean that individual financial planning clients are improving their own financial position and cash flows. Who benefits from higher component values of GDP? It depends on the component. If the component is:

C – consumption, then those who sell the goods and services consumed benefit. If the component is:

I – investment, then those who sell the homes and fixed assets held for investment benefit. And if the component is:

G – government, then Uncle Sam benefits.

The result we got was intuitive: sound financial planning (which includes savings!) may actually reduce GDP in the short run. However, GDP’s loss is the client’s gain. A savings program will undeniably put clients in a more enviable position: the numerical losses of the businesses and governments producing the goods they buy are, quite possibly, directly proportional to the numerical gains that clients reap from sound financial decisions. The GDP question, at its core, appears a zero-sum game.

Is it, though? To find out, let’s see what happens to GDP after the client retires. If she continues to earn 4.85% on the $100,000, she can take out

$6,666 at the beginning of each year (figured out with a financial calculator). Ignoring TVM again, this amounts to a lump sum of

25 x $6,666 = $166,650.

What about the components? They are:

X (taxes) = 30% x $166,650 = $49,995

I (investment) = (1 – 30%) x 25% x $166,650 = $29,163.75

C (consumption) = $166,650 – X – I = $166,650 – $49,995 – $29,163.75 = $87,491.25.

Added up, these mean that $166,650 is directly added to GDP during the client’s retirement. If we subtract the $85,108.80 that GDP “lost” during pre-retirement, we get a net GDP addition of

$166,650 – $85,108.80 = $81,541.20.

This is net money added to GDP during the client’s life as a result of financial planning.

From this we can deduce that financial planning (specifically, savings!) appears to have three characteristics when it comes to GDP:

1)      It reduces GDP in the short run;

2)      It increases GDP in the long run; and, most importantly,

3)      It increases GDP in the long run by more than it decreases GDP in the short run.

This result is quite dramatic: it intimates that one of the best long-term methods of enhancing the GDP of a nation is to help individuals improve their own financial position and cash flows. It also strengthens the classical position of financial planners: that it’s defensible (and even imperative) to tell your clients to save more money! “The economy helps those who help themselves” is one possible aphorism expressing this result. Just as public companies need to avoid the “earnings game” of sacrificing long-term profitability in the interest of earnings for the current quarter, so planners need to steer their clients away from the shoals of overspending with the tenuous argument that “it’s good for the economy.” What’s best for the economy is what’s best for the individual client, in this case. No wonder it’s been called “Grossly Deceptive Product!”*********

(See final note at bottom.)**********

*Calculated with a financial calculator. You can also solve for PMT using: FV = PMT {[(1 + I) exp N – 1] / I}.

**X – M is ambitious for this calculation: it’s probably simpler if we keep the problem “at home” for now.

***Source: http://www.economicswebinstitute.org/glossary/cons.htm

****Source: http://people.stern.nyu.edu/nroubini/bci/Investment.html

*****The multiplier effect is a very primitive way of expressing the “extra” value of $1 spent now rather than saved now. It is the “juice” that consumers inject into an economy’s GDP when they consume instead of defer. It’s also completely arbitrary in this case, so don’t think that it’s an easily definable number – it isn’t. This is for illustrative purposes only.

******The client only would have had after-tax savings to spend on consumption or investment.

*******Assuming she won’t pay the mortgage anymore: she goes and decides to rent instead, which is an extreme assumption. But it is illustrative here.

********Source: Aggregate Supply and Aggregate Demand, Michael J. Parkin.

*********Source: The Economist.

**********Note we left out a very important part of the calculation: the client’s “enjoyment rate of return” on spending now instead of later. This is a qualitative consideration – but it can be fatal to overlook it as a financial planner.

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