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The following is excerpted from Wade Pfau’s book, How Much Can I Spend in Retirement?: A Guide to Investment-Based Retirement Income Strategies, which is available via the Amazon link on this page.
When it comes to financial planning, Vanguard’s “Alpha” and Morningstar’s “Gamma” quantify only a portion of the value an advisor can add in a client relationship.
For instance, neither study considered how to incorporate home equity into a retirement income plan. The naïve strategy is the conventional wisdom of using a reverse mortgage only as a last resort option in retirement. But if you read any of my pieces on reverse mortgages from earlier this year, you will understand why that is a bad idea.
In addition, these Vanguard and Morningstar studies are naturally somewhat limited in what they can examine quantitatively. There are many other ways financial advisors may add value that are harder to quantify, such as ensuring you make the right beneficiary designations within an estate plan, are properly insured, and are not missing important strategies to save on taxes. One significant mistake in any of these areas could unravel years of good planning.
Advisors serve as a type of insurance policy. They provide support to avoid normal life mistakes that come with a lack of experience.
Life consists of many economic milestones, like retirement, as well as spurious “opportunities,” like buying into a timeshare, and various potential mistakes driven by behavioral considerations. Working with someone who has seen these situations hundreds of times can be helpful to steer you in the right direction and avoid costly mistakes.
With retirement, it is important to consider how declining cognitive skills associated with aging will make it increasingly difficult to self-manage your investment and withdrawal decisions. For households where one person handles money matters, surviving household members will be especially vulnerable to mistakes when they outlive the family financial manager. Developing a strong relationship with a trusted financial planner can help with both of these matters.
In terms of cognitive decline, a research article by Michael Finke, John Howe, and Sandra Huston, “Old Age and the Decline in Financial Literacy,” outlined the situation well. They provided a financial literacy test to older populations and found that financial literacy tends to decline by about 1% per year after age 60, but financial confidence remains the same.
Other research from David Laibson at Harvard University revealed reduced numeracy with age. It becomes harder to perform basic arithmetic calculations and understand the nature of risk, not to mention answering questions such as which number is smaller: 1/100 or 1/1000?
Declining abilities to do financial calculations and other types of cognitive impairment make it increasingly difficult to manage a complex investment and withdrawal strategy as you age.
It is important to plan ahead and make binding decisions before cognitive impairment sets in. Examples of these binding decisions include working with a trusted financial planning firm that can be on the lookout for cognitive impairment and help arrange for necessary additional help or using an income annuity (which David Laibson has called “dementia insurance”) to lock in an income stream and reduce the need for portfolio management skills.
Since confidence in your financial skills does not decline with age, plan for these possibilities ahead of time.
Exhibit 1: Financial Literacy and Confidence from Age 60-88
Source: Finke, Michael S., John S. Howe, and Sandra J. Huston. 2011. “Old Age and the Decline in Financial Literacy.” SSRN Working Paper #1948627 (August 24).
Can a financial advisor be cost effective? Ultimately, that depends on your answers to a series of important questions:
- Do you have the time, energy, interest, knowledge, and desire to implement all of these decisions on your own? Do you enjoy financial planning?
- Will you overcome the inertia of inaction to put together all the various parts needed to create and implement an effective and coherent overall plan?
- Will you continue to periodically update your plan?
- Have you determined how to make sure your planning will be maintained properly if other family members need to take control of it?
- Are you working with a comprehensive financial planner who does more than just manage investment portfolios and is capable of implementing good financial planning decisions?
If you have the time, interest, energy, knowledge, emotional detachment, and desire to do your financial planning on your own, then you may make an excellent advisor. If your advisor is less than capable, you might be better off saving yourself the fee or taking your business elsewhere. Otherwise, consider that both of these studies demonstrate how working with a financial advisor can lead to net positive outcomes and be cost effective, especially as you age. It doesn’t take much to improve your standard of living through better decision making, even after accounting for any fee related to planning advice.
Wade D. Pfau, Ph.D., CFA, is the curriculum director of the Retirement Income Certified Professional program at The American College in King of Prussia, PA. He is also a principal and director at McLean Asset Management and RetirementResearcher.com.
Read more articles by Wade Pfau
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
