Closing this year's Morningstar Investment Conference in Chicago was Harvard's Robert I. Goldman Professor of Economics David Laibson. As a prominent authority in the realm of behavioural finance, he addressed the hugely ignored topic of cognitive decline among the elderly, which can have enormous consequences in their financial decision-making abilities.
This is an especially germane topic given that significant amount of wealth is held by the retirement-age population and is increasingly in self-directed accounts. But intersecting this important time of financial decision-making is a decline in investors' cognitive functioning--a decline, as Laibson drove home in his presentation, that affects many more investors than you might think.
What's at Stake?
Laibson provided some illuminating statistics: The average assets across all net worth segments of US households peak just at post-retirement age, with just more than $1 million. Moreover, the balance sheet of US households has a net worth of $53.1 trillion, with $18.1 trillion being held by the vulnerable population of those over the age of 65. According to Laibson, the vital question to ask in light of these numbers is: What are we going to do as society--as advisors, as regulators, and as concerned citizens--to help this group to spend and invest this significant amount of money wisely?
The Decline of Intelligence
Laibson highlighted two kinds of intelligence. Crystallised intelligence is the ability to accumulate wisdom, experiences, skills, and knowledge. This type of intelligence rises until age 60 when dementia is more likely to set in. Fluid intelligence is the ability to solve new problems. This type of on-the-fly intelligence peaks at 20 and then declines rapidly.
According to memory and analytics tasks performed by all age groups, 80-year-olds perform at the bottom 16th percentile. Moreover, age is a greater hindrance to economic rationality than is being low-income or of low-education. As a result, the retired are among the most impaired in terms of economic reasoning. The prevalence of dementia (or cognitive impairment) plays a huge role. Laibson noted a startling but compelling statistic--the likelihood of developing dementia doubles with every five years of age after age 60.
Even where dementia has not occurred, there might be signs of a condition called Cognitive Impairment, Not Dementia (CIND). Sixteen percent of those in their 70s, 30% of those in their 80s, and 40% in those in their 90s are in that in-between stage where they have CIND but have not degenerated to the point of dementia. Those who fall in this demographic still largely control their own money. According to Laibson, 10 million Americans have CIND or dementia with 2 million new cases every year.
The Visibility Problem
One reason why these statistics might be surprising is that the elderly who suffer from cognitive decline or dementia often fall through the cracks. Laibson said that this is because they are less visible; they are not with us in day-to-day life (we won't see them at the mall or the movies), and we also generally don't want to see them (Laibson pointed out that most people would rather see a documentary on killer whales versus Alzheimer's disease). The public generally sees the glamorised image of the elderly (for example, The Golden Girls) versus the reality of the cognitive decline that comes with growing older.
At Risk for Abuse and Fraud
What are some concrete fallouts of cognitive decline on investors' financial health? Laibson said 20% of Americans 65 and older report that they were taken advantage of financially--such as being sold inappropriate investments or investments with unreasonably high fees, or they are the victims of outright fraud. Laibson pointed out that this is most likely an underreported figure. In terms of investment performance (based on risk-adjusted alphas for different age groups), middle-aged investors do well while the elderly do quite poorly--in fact, they are disadvantaged by up to 300 basis points a year, Laibson said.
Psychological Resistance
Unfortunately, despite these statistics, the elderly are generally resistant to planning for their own cognitive decline. Laibson highlighted a few notable reasons for this:
-- lack of meta-cognition (we may acknowledge that we have bad memories, but we don't know the extent of the decline).
-- need for control
-- over-optimism ("dementia won't happen to me" )
-- procrastination
-- aversion to complexity
-- aversion to annuitistion (the fixed payments of annuities could be well-suited for this population, but about 75% of defined-benefit pensions are elected to be received as lump-sum payments even though the net present value of annuities is significantly higher).
Planning for Cognitive Decline
Laibson underscored the importance of starting early. His presentation included a list of some ways investors can plan for cognitive decline. These are effective guardrails to establish before cognitive decline begins:
-- durable (or springing) power of attorney
-- living revocable trust
-- living will
-- health-care proxy
Laibson also stressed that advisors and family should not wait until cognitive functioning declines to discuss these long-term strategies, but rather they should get going while the client is still cognitively healthy.
He also provided some "nudges" to get investors on board with planning:
-- Make estate planning the default for every 65-year-old
-- For advisors, establish regular check-ups with clients (update trustee lists, verify that beneficiaries have been appropriately designated, and so on).
-- At the end of each check-up, schedule an "appointment" for the next check-up
-- Encourage family involvement
-- For advisors, take action on the spot and work through decisions immediately, rather than inundating clients with information and delaying the actual investment decision. Also, advisors should keep decision points simple and one-dimensional: (for example, ask clients, "Do you want to take more risk or less risk?")
Laibson also encouraged advisors to find a way to give clients a sense of control over their finances while also protecting them for adverse outcomes. For example, he suggested giving clients some "play money" by segmenting their portfolios into two parts (the majority is carefully monitored by the advisor, while a small portion is made available to the investor's whims). Another idea is to create "a sandbox" for investors by allowing them to choose from an assortment of equally appropriate funds, so anything the investor selects will not put their assets at undue risk.
Regulatory Proposals
Laibson's presentation also included some key regulatory proposals:
-- Require power of attorney designation after age 65
-- Establish a fiduciary duty for IRA advisors and asset management companies. Retirees should be at least as well-protected as middle-aged adults investing in 401(k)s, Laibson argued
-- Create a class of safe-harbour financial products (diversified low-fee funds with an automatic monthly drawdown mechanism after age 70, low-fee annuities and deferred annuities, and other retirement products approved by regulators).
Final Words
Laibson ended his presentation with three key takeaways for the audience:
-- About half of the population in their 80s suffers from significant cognitive impairment
-- Existing fiduciary protections are far greater for 50-year-olds (people who arguably need the least protection) than 90-year-olds (who need most protection).
-- $18 trillion is at stake ($10 trillion in assets under management and another $8 trillion in real estate).
