Plan for Incapacity Before You Need To

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?

<TRANSCRIPT>

Laibson: Rule number one, you can't act as if once the cognitive decline steps in, you're going to somehow fix the problem then. You've got to fix it ahead of time. It's got to be anticipatory, because once the problems comes in often we don't know that we have cognitive decline. So, we keep doing what we are doing, and that can be disastrous. So, if your plan in your 60s was to be an active investor, market timing all that stuff, and you think that the day will come when I'll have cognitive decline, and then I'll become be a passive investor and buy a low-cost index fund...

Benz: ...then I'll be able to realize it's time to shift around what I'm doing, that is not a good idea.

Laibson: You've got to basically put everything in place ahead of time. So, I would first suggest that however successful you were with all your active stuff, buying and selling individual securities, market timing, whatever you did--often [market timing] is not even successful for 50 year olds--

Benz: --right.

Laibson: But, whatever your thinking is as an investor, begin to wind that down starting in your 60s, and really that should be wound down completely by the time you turn 70. There is no scope for that because at some point, there is a very high likelihood of cognitive decline, and at that point, picking individual securities, all of that active management of your own portfolio is very risky and likely to get you in trouble.

The second thing that you want to do is focus on publicly traded securities. So, when someone knocks on your door and says, "Have I got a deal for you! Invest in my restaurant, invest in my mall, invest in whatever crazy product they are offering you, the answer has to be globally no."

So, for the older investor, it should be very simple vanilla assets. Fine, in equities, appropriate. But equities perhaps in an index fund with very low fees--that would be the safe environment for that older investor. That's one issue.

The second issue is to make sure you have all of your estate documents in order, and they are basically four estate documents, but again you can't wait to sign or execute until decline sets in; you've got to execute them much earlier. And since they have bearing on family structure, really the minute you have kids or a spouse, that should be set in place.

What are those documents? You should have a durable power of attorney or a springing power of attorney. You should have a living revocable trust that protects your assets. You should then have two health-care documents. A health-care proxy, that basically assigns someone to help you make health-care choices if you are no longer mentally competent, and you should have a living will, which is providing instructions to that person about what kind of care you'd like. How extensive intervention do you want if you are, say, on life-support.

Benz: So you also think the financial services industry has an opportunity to craft some products that help address this issue directly. I am wondering if you can quickly summarize some of the features of those products that you'd like to see appear?

Laibson: So there's an enormous opportunity. The population 65 and above has $18 trillion of net worth, and they are not being well served. They are not being protected from mischief, so we need to protect them from people offering them products that are problematic. How do you create a sandbox in which they can play, they can have a sense of control? They can still in some sense manage their destiny, but in a safe place, protected from people offering them nasty stuff.

We need to ensure against longevity risk. What if I live to be 105? We want to basically pay out to them in that state something like an annuity. Of course annuities have a bad name, but some product that is insurance against longevity risk.

You want to insure against inflation risk. So if I am just holding a nominal bond portfolio, when we have a high inflation period, it's a disaster for those households. Social Security is inflation indexed, but most annuities that are purchased today are not. So we've got to get inflation risk in the package as well.

And of course the most important piece, which I have just kind of put last, is we need to have a payout strategy. So how do we take this wealth that we've accumulated, worked so hard to accumulate over our working lives, and turn it into a consumption stream that gives us pleasure in those last years of life between 65 and 105? We need a strategy for spending that money, leaving some of it to our heirs, but spending a lot of it, and spending it in a way that makes us feel secure rather than terrified of running out of our money.

Benz: Well, David, thanks so much for sharing your insights today. We appreciate it.

Laibson: Thank you very much. Pleasure.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.