Mitigating the Risks of Cognitive Decline

Christine Benz: Hi, I'm Christine Benz for Morningstar.com and I'm here at the Morningstar Institutional Conference. Cognitive decline later in life is an important but under-discussed issue. Joining me to discuss that topic is Terry Odean. He is a professor of finance at UC Berkeley.

Terry, thank you so much for being here.

Terry Odean: Thanks for inviting me.

Benz: You've got a great online course which features a number of videos about various personal financial planning tasks and investment-related tasks. One topic that you tackled was an important topic, which is cognitive decline as we age. Let's talk about that phenomenon in general, why it's an issue, why investors should have it on their radars.

Odean: Okay. Well, it's a fact that as we get older--on average, not every single person--but on average our ability to make finance decisions declines. One study showed that after 65 or 70 on average people's scores on financial literacy tests were dropping about 1% a year. About a third of people will eventually--I think it's after or 80 or 85--have some dementia. Another third have some form of cognitive decline. So, this is real and the first step is to acknowledge that it could happen to you. It might not, but it could and it's something to think about and plan for.

I got very interested in this because my dad died a little less than a year ago, but what caught my attention was he had severe stroke and ended up in a care facility and I went and started reading through--I was going through his papers and trying to get the house in order as it were, and I came across a letter which was a letter acknowledging that he had canceled his long-term care policy about three years before he ended up in a long-term care facility and this was a policy he had had for 20 years. And I was so shocked I said to my mother, "Did Dad cancel his long-term care insurance?" And she said, "Yeah, we canceled that a few years ago; it was really difficult to cancel."

Benz: So, it wasn't a sin of omission. It was something they were aware of.

Odean: No, it wasn't. Right. He didn't forget to pay it. He decided to. Now, from a financial point of view, this made no sense. He had had the policy for 20 years. He was uninsurable at the time that he canceled it. He needed a chair that kind of assisted him in getting up. He had already had a couple of bad falls. So, it was really not a reasoned decision. It was probably an emotional decision.

Since this happened and I've told this story to people--generally people respond with…

Benz: A similar story.

Odean: A very similar story. Here is what my grandmother did, here is what my mom did. There are a lot of mistakes made by people in their--particularly by the time they get into their 80s. So, I think it's really important to acknowledge that this sort of decline could happen to yourself. It could happen to your parents and make a plan because it's going to be very hard to deal with it. You want to plan while you can still make good decisions. Now, I don't have a perfect solution. I have some ideas of things that people can do. And one of the things happening too is it's becoming a bigger issue because the form--the type of pensions we have these days are like 401(k) plans, 403(b)s….

Benz: They are not pensions. That's the issue.

Odean: Exactly. They are what we call defined contribution plans, which when you retire you have a bunch of money and you have to decide how to invest and spend that for the rest of your life and that's a pretty difficult thing to figure out even when your reasoning is working perfectly. But you run the risk that you make a bad decision with your life savings or with a large portion of your life savings somewhere down the line. In my dad's case, that wasn't a risk. He had a traditional pension. He was a high school teacher and he retired, he had a pension. Dad could make a mistake with this month's paycheck but he couldn't make a mistake with the upcoming ones. So, I think this is an important issue.

There are a few things that won't solve the problem but could help. Some people might consider getting a deferred income annuity. So, this would be, say, when you are 70, you buy an annuity that when you turn 85, we'll give you some income. You don't spend all your money on it, but you make an investment. And this basically gives you some security that even if you do make a mistake between now and 85, you'll have an income when you get there and when you probably aren't in a very good position to be making decisions.

Another approach is you have--get yourself a financial confidant, someone whose judgment you trust and who is going to have your best interest in mind. This could be a financial advisor, it could be--in some cases it might be one of your children; in some cases that is not such a good idea. And get in a habit of discussing, even briefly, financial decisions with that person before you make them, even while you are still really confident in your abilities and you've got a clear mind, but habits are very powerful. So, if you get in a habit that before you make any financial decision, any big decision about investments, about insurance, you talk to this person.

I plan to do this with my son-in-law. For example, next June at this point I'm going to let my life insurance expire. My children are all grown up and they have their own households and lives and stuff and my wife would get my pension if I died prematurely. So, I think it's a reasonable decision, but I'll call up my son-in-law who I now have designated the person I run decisions by and say, I'm planning to do this and here is why and he will hear me and say, that's fine but one of these days maybe I'll call him up and say there is this great swampland in Florida; I can get it for a great price. Now, it would be the point he was certainly going to say, "Well, Terry, I think you should hold off on that and not move forward."

Now, it's not a perfect solution because you could break your habit. You could…

Benz: Or override the person.

Odean: …overrule that person and people might want to consider something more binding. I mean, you could put all of your assets into a trust and make someone else the trustee or make someone a co-trustee where you actually needed both of you to approve any major decisions. So, as I say, I don't have--it's not so much that I've got the perfect solution…

Benz: The answer.

Odean: …but the first step is clear, which is to acknowledge that this is a real issue. It's going to happen to many and possibly most of us. We're living longer and cognitive decline starts to set in, financial decisions have gotten more complicated not less complicated and it's good to start thinking about, well, what's my plan, how am I going to deal with this and make the plan well. What you're basically doing is how can I protect myself today from bad decisions that I haven't yet made.

Benz: One of your overarching points is to do so preemptively because by the time you begin undergo some cognitive decline you might not be aware that this is a problem.

Odean: Yeah. Well, this is another issue that comes up. Some of the studies have found that as people's ability to make financial decisions declines, oftentimes their confidence stays at the same level or in one study actually went up a bit. So, you may be losing the ability to make sound financial decisions and not even aware of it. So, what you have to just--you have to admit that this may happen to me. I may not know it's happening until I've made a mistake. So, let's make a plan now that makes it much less likely that I'll make a mistake if I lose the ability to make sound decisions.

Benz: Terry, it's such an important topic. Thank you so much for being here with us to discuss it.

Odean: Thanks for inviting me.