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By Christine Benz | 06-10-2011 03:27 PM

Plan for Incapacity Before You Need To

Every investor in their 60s should be prepared for the large possibility that they could experience a cognitive decline in their 80s, says Harvard professor David Laibson.

Christine Benz: Hi I'm Christine Benz for Morningstar. I'm here at the Morningstar Investment Conference with David Laibson. He is the Robert I. Goldman Professor of Economics at Harvard. David, thanks so much for being here.

David Laibson: My pleasure.

Benz: So David you did a terrific presentation today in which you talked about how we as individuals as a group tend to experience fairly significant cognitive decline later in life, and that can affect our financial decision-making. I'm wondering if you can quickly summarize some of that data that you've been sampling?

Laibson: So in a nutshell, there are two kinds of intelligence: crystallized intelligence is wisdom and experience, and happily that just increases over the whole life course. But fluid intelligence, our ability to solve new problems, peaks at age 20 and declines after that. So we have these two forces fighting each other or getting less good at solving new problems, but we're gaining more experience.

It turns out that our peak ability to make good choices in the world comes in the mid-50s, and after that there is a decline. So we have to think about that, and of course dementia makes that decline even more severe.

Unfortunately, in the 80s, about half the U.S. population either has full blown dementia or cognitive impairment, which is short of dementia, but still a clinical diagnosis--half the population. So, every investor in their 60s should be preparing for the possibility, an enormous possibility that things are going to go badly in the 80s.

Benz: So can you give an example of how individuals might struggle with financial choices later in life. Can you give us an example of data that demonstrates that?

Laibson: Sure. So you can look at risk adjusted returns for people in their 80s; it's about 300 basis points below baseline. So they're making poor choices in terms of fees, in terms of lack of diversification.

You can look at interest rates, that older adults pay when they borrow say for a home equity line of credit or a home equity loan--they end up paying about 100 basis points more than middle-aged adults. Even though the older adults turn out to be better risks, in other words, they have better FICO scores at older ages on average and they have lower default rates. But they are less able to bargain effectively for those good rates, so they end up paying more.

So we see lots of ways in which the older adults end up with bad outcomes, simply because in this environment, in this economy, in the free market economy, you've got to be a smart, sophisticated consumer to get the best results.

Benz: Right. So I am wondering if you can share some practical tips for people watching this, who might be concerned, well this could happen to me--how can I put some safeguards into my financial program, on my investment plan to ensure that I am not vulnerable if in fact my cognitive functioning does tail off later in life?

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