What is Life Cycle Finance?

Life cycle theory is one of the more exciting and useful areas of research in personal finance. In broad terms, it represents the body of economic theory and knowledge that examines how individuals can make wiser and more beneficial decisions about spending, saving, investing and insuring over their lifetimes. There are several concepts underlying life cycle theory. We’ll discuss two of them in this article.

First is the premise that individuals will be making decisions about how to manage their wealth across a planning horizon that can span 60 years or more. This period begins at the start of a career at age 25 until the end of retirement at 85 or older and includes different life phases. The second assumption, derived from the field of classical economics, presumes that people are rational, have a firm grasp on self-control. Therefore, they will deploy their income and assets in a way that will enable them to maintain the smoothest and highest possible standard of living throughout their lives. This concept is known as “consumption smoothing”.

For example, following the consumption smoothing framework, a person might make a series of spending, saving, investing and insuring choices that allow them to maintain inflation-adjusted spending of $75,000 per year over their entire life. This is presumed to be preferable to a series of financial decisions that result in a $95,000 per year standard of living during their working years but only $55,000 during retirement or vice versa. The rationale behind this concept is intuitive. Given the option, most people would not choose to live an opulent lifestyle while they are working and then because they have failed to save enough, be forced to live frugally in retirement when they have more time to enjoy themselves. Conversely, they also wouldn’t want to live an unnecessarily frugal life throughout their careers in order to enjoy a lavish lifestyle that they may be unable to enjoy in retirement. In short, the main goal of life cycle finance is effectively to distribute a person’s income from the working and earning years over their entire life.

In theory, in order to accomplish this goal, individuals would borrow early in life when income and assets are low and needs are high. This would include paying for college, buying a car and purchasing a first home. Later in life when income is rising and basic individual and family needs have been satisfied, saving becomes important in order to fund the later years when they leave the workforce and rely on those assets to supplement Social Security, employer pensions and other income. That’s the theory. But as 20th-century philosopher and Yankee Hall of Famer, Yogi Berra has been attributed as saying, “In theory, there is no difference between theory and practice, but in practice there is.” In a computer model, applying consumption smoothing is relatively straightforward. In real life, however, many of the important financial choices we face are shrouded in uncertainty and fraught with risk. For instance, we can’t predict with accuracy the length or trajectory of our career earnings, the financial needs of our families, the returns we will earn on our investments or how long we will live in retirement.

In future posts, we’ll look at ways the average investor can use the life cycle model to make better financial decisions and improve the economic outcomes for themselves and their families.

The Value of Human and Financial Capital

The financial life cycle model involves the process of managing two distinct, but related assets that individuals have on their personal balance sheets. If managed properly both can be used to fund a person’s liabilities (spending) throughout their lifetimes and help them reach their most important goals.

The first is the one we are all familiar is known as financial capital. It represents the tangible wealth in the form of savings, investments, equity in real estate and other assets that we have accumulated and can use to fund consumption. In other words, these are assets that can be sold at any time, and the proceeds spent. When planning for their futures, especially retirement, calculating, preserving and growing financial capital is almost always the primary focus of individuals and their advisors. However, this limited view ignores an intangible but what is for most people a more significant asset, their human capital. Read more

Sales Pitch or Sound Advice – Part Two

In my last blog post I talked about the basic differences between brokers and Registered Investment Advisor (RIAs) including how they are governed, their compensation arrangements and their legal obligations to clients. In this article, I’ll explain the affect that suitability and fiduciary standards can have on an investor’s financial security.

Objective industry experts have long argued that while in theory both suitability and fiduciary standards limit self-serving behavior, in practice the suitability standard provides such wide latitude for brokers’ recommendations that it is meaningless in protecting the consumer. After all, this is the same standard that introduced complex, conflict-ridden, commission-laden products including non-traded real estate investments and variable annuities to the investing public.

Under the guise of suitability, sales reps regularly recommend investments that generate the fattest margins for their employers and the biggest commissions for themselves, even if other investments might offer the client lower costs and better returns. In other words, in order to meet their minimum obligation the recommended investment is merely required to be “suitable,” not necessarily the best for the client. That distinction could make a big difference in your bank account. Imagine that you are investing $100,000 in a stock fund toward your retirement. A broker under the suitability standard recommends a fairly typical fund (we’ll call it Fund A) that pays a commission of 3% upfront, has an annual expense ratio of 1% and additional undisclosed fund turnover expenses of 1%. A Registered Investment Advisor, on the other hand, operating under the fiduciary standard offers an almost identical fund (call it Fund B) except there are no sales commissions, the annual expenses are 0.2% and fund turnover costs add another 0.2%. Assuming both funds earn an average annual return of 7% over a 25 year period, Fund A accumulates $318,000 compared to $491,000 in Fund B. Taking 100% of the investment risk while forfeiting over $170,000 in investment returns is not something an informed investor would accept. In the above scenario, a “fiduciary standard” would prohibit an advisor from recommending Fund A.

Things get dramatically worse for investors (and better for brokers) when we leave the relatively transparent and competitive realm of mutual funds and move into the arcane world of non-traded real estate investments, private partnerships, variable annuities, and other financially engineered products. While some of the country’s most distinguished economists and investment experts have warned that these products have no place in an investor’s portfolio, analysts estimate the annual transfer of wealth from consumers to sales reps and their companies from these products has reached into the tens of billions of dollars.

The rise in questionable sales tactics and other abuses perpetrated by financial industry participants against unsophisticated retail clients have attracted the attention of regulators and consumer advocates. Among the most important objectives of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) was the establishment of robust new fiduciary standards for the broker-dealer industry. Under that law, the SEC was mandated to study the effectiveness of the existing standards of care in protecting investors and propose solutions where warranted. In early 2011, the SEC delivered their report titled Study on Investment Advisers and BrokerDealers which recommended that the Commission replace the current disjointed regulatory scheme with a new uniform fiduciary responsibility for both broker-dealers and investment advisors. Not surprisingly, seeing billions in profits at risk, the pushback from the industry was swift, intense and ultimately effective. Four years after the bill passed, efforts to level the playing field for the retail investor have stalled.

From both a common sense and public policy standpoint, the problem is obvious, and the solution is simple. The savings and economic security of millions of American workers and retirees is being undermined by conflict-ridden advice and perverse incentives that encourage financial institutions and their agents to recommend inappropriate investments carrying substantial undisclosed fees and risks. The most effective way to protect consumers is to impose a fiduciary standard on all market participants dispensing financial and investment advice to retail customers. Requiring all players to act in their clients’ best interest and align the interests of investors and their advisors would make it a win for everyone.