For more information about this topic, please read the accompanying article in this issue of Advisor Perspectives, The Debt Burden Facing Retirees.
A George Washington University professor says advisors should target clients based on how financially literate they are rather than on their level of assets.
I caught up with Annamaria Lusardi, the Denit Trust chair of economics and accountancy at The George Washington University School of Business, to get her thoughts on how the findings of the new working paper, “Understanding Debt in the Older Population,” more specifically relate to financial advisors. Lusardi coauthored the study with Olivia S. Mitchell, the IFEBP Professor of Insurance/Risk Management & Business Economics/Policy at The Wharton School of the University of Pennsylvania, and Noemi Oggero, a post-doctorate fellow in the School of Management and Economics at the University of Turin in Italy.
I found it very interesting that even answering one additional financial literacy question correctly is associated with better credit records and retirement planning. Can financial advisors make a bigger difference with financial literacy by doing more to evaluate clients? Would it help address some of the issues you raise? Should more advisors target the groups that need the most help?
We have done a lot of research on financial literacy and have shown that it helps in every dimension: It helps people to plan more for their retirement, to invest better, to accumulate more wealth, to have precautionary savings, to better manage debt and much more. If advisors want to help people in all of their decision-making, improving financial literacy would be a way to do it. Moreover, clients who are more financially literate are better clients; they would be able to better appreciate the advice that is offered to them and also to follow through on that advice.
Financial literacy is the missing link; without some financial literacy, it will be hard for clients to get the full value of the advice. What this means is not that advisors should bring people back to a classroom, but that advice should be accompanied with explanations and information, so that clients better understand what is provided to them. And advisors should target their clients in that sense. It would be good to differentiate among types of clients depending on their level of financial literacy (which I do not think it is currently done): If people have the same income and the same wealth, but different levels of financial literacy, the advice should not be the same. Olivia Mitchell and I have devised a list of questions that provide a simple test (called the “big three” or the “big five”), so it is very easy to do so now.
What kinds of financial literacy education should financial advisors be sharing with their clients in different age groups that might help them improve their chances of having less debt later in life? How and when should financial advisors be discussing debt with their clients?
Advice should be at 360 degrees and not just at the asset side of the balance sheet, so financial advisors should always discuss debt (more on it below). According to our research, everyone deals with debt and carries debt, now even the older people; debt seems to be a consistent feature in the life cycle of people, from the beginning of their careers until late into retirement. The financial education here can be pretty easy. For example, by teaching clients how to better manage credit cards, one may be able to help clients right away. (The rates charged on credit cards are so much higher than what one could get on almost any investments). Moreover, and importantly, one should aim to have the best credit score, which has implications on almost any financial transaction one would do (from getting a mortgage, to renting an apartment, to having an insurance policy and so on).
Understanding debt is a major problem among respondents. Do you think that lenders do a good job of explaining interest compounding to borrowers and how debt accumulates? Should lenders or someone else be responsible for this education, and who should it be? Or is the problem more that people find it hard to make tradeoffs so that they have less debt? Having more children is associated with more debt – is that an issue that can be addressed in some way without the answer being just to have fewer children?
I do not think that lenders do any teaching, nor that they have an interest in doing any such teaching. We should teach personal finance in school. Only 21 states require courses in personal finance and it is not clear why this is the case. Are the states that don’t require personal finance courses acting under the impression that students will not make financial decisions right out of school? How about the $1.7 trillion of student loans we are facing? These are issues of prime importance. Times have changed and the schools need to adapt to those changes. I would also recommend financial education in the workplace, in particular for those who were not exposed to financial education in school. Financial advisor associations today should talk not just to the Labor Department but to the Education Department as well.
The fact that having children is associated with more debt has to do with the fact that people with children face more costs, and therefore have to be even savvier in managing their resources. Of course the recommendation is not "have fewer children," but that advisors who advise families with children should be even more sensitive to the needs and constraints associated with having children.
How might people minimize or protect against health shocks later in life? So many people face health issues as they age and health costs continue to rise – what do you think could be done to reduce or control this sort of debt?
We want to stay away from providing generic advice that applies to everybody; one size does not fit all. What our research makes clear is that a lot of debt is connected with health costs, so advisors should pay attention to that as well. A lot of health insurance contracts today are high-deductible ones, where people should invest in HSAs and have liquidity to pay for the (high) out-of-pocket expenses. Also, while we live longer today, we are also going to face a variety of health issues, in particular later in life. In other words, a longer life is an expensive one. Another problem is that people often are not taking care of just their health but the health of parents, and this is something that advisors should consider (more on this below), as one may even have to step away from regular work or his/her job to do so.
You note that student debt is a significant issue for people nearing retirement now. Student debt has continued to grow and become even larger for people who have attended college in the last decade or so. What are your thoughts on how this debt will impact millennials and gen-z as they get closer to retirement?
According to our research, many millennials took on this debt without fully understanding its implications. This is not a good sign, as it means it was not planned or understood, and it is again linked to financial literacy. High levels of debt have the potential implication of making young people save less for their retirement, and also increase their worries and financial anxiety. According to the 2018 National Financial Capability study, many young people suffer from financial anxiety and thinking about their personal finances makes them stressed.
Financial advisors have long been focused on wealth accumulation and are most often paid based on investments. How could you see them being compensated in some way to help their clients manage debt and provide financial literacy for more people?
Financial advisors should be like the family doctors. To understand how one is doing, a check-up needs to be done. One cannot limit it to just looking at assets but, rather, at the entire balance sheet and also at what people are doing. (They could be helping children or aging parents.) Moreover, like doctors, they should focus on where the problem is. If one has wealth but a very low credit score, there is a problem. Moreover, a clear and simple way to increase wealth is having people pay credit cards in full. (Where else can you get such high interest rates?) I can see advisors being rewarded for achieving targets. One should remember that the objective of people is not to save more or borrow less, but to achieve their dreams, to be "well." if you miss that, clients will not come back.
Dorothy Hinchcliff is the editor of Advisor Perspectives.
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