Having successfully infuriated a significant percentage of a key group of potential buyers of my book (e.g. actuaries), I’ve decided to antagonize a few more by sharing some thoughts on why most Financial Planners (including some of the most sophisticated ones out there) generally get it wrong; and not just a little wrong, but fundamentally and seriously wrong.
I am not addressing the obvious problems with Financial Planners who are also marketing particular products (e.g. insurance, stocks, annuities etc) and who therefore provide advice that may be tainted with self-interest. Rather I am talking about the ones you can trust, i.e. the ones who are sincerely trying to give you advice that will help you make better financial decisions
I believe that even the (relatively few) independent fee-based advisors that meet the above criteria are likely to fail you for 3 main reasons. The first is due to their general reluctance to take account of (or even acknowledge) the importance of personal rates of discount. This was the subject of my previous post (the one that got actuaries so upset) and a subject on which I have probably said more than enough (at least for now). The second reason is the (to my mind) unreasonable confidence that Planners (and the experts that they rely on ) have in their ability to predict the future. I will address this aspect of financial planning in much more detail in the future, but before I get to that issue, I want to discuss yet another issue that is even more important than the first two.
Specifically, I want to talk about something you don’t have to be an actuary to appreciate and may actually seem obvious – and that is the failure of almost every Financial Planner I know to approach financial decision making from a holistic perspective, taking into account your entire balance sheet including all of your assets and liabilities as well as your future income and expense streams (much of which is uncertain and related to aspects of your life that Financial Planners may not have access to). Don’t get me wrong, a good Financial Planner will likely ask you for all the information that theoretically could go into the development of that holistic balance sheet, but almost none of them put it all together to help you look at the big picture. I would propose that the failure to do so can render the advice they give almost meaningless.
I say this because, in my experience, even though there are two sides to every balance sheet, it is the asset side that advisors spend almost all of their time on. To my mind the liability side of an individual’s financial world is just as important, and how you manage your liabilities (debt and the Present Value of future expenses) is not only related to your ability to manage your assets (i.e. save and invest) but can actually have a bigger impact on your financial health than the asset allocation strategies that are often the core of what your advisor is concerned with.
But it’s worse than that, not only do advisors typically only focus on assets and income, but they also tend to ignore the single biggest asset that most individuals have, and that is the equity they have in their house. The rest of this post will talk about some of the considerations you should think about regarding your assets and liabilities (including debt and home equity) while you are working and “accumulating” assets (and liabilities), and next time we will talk about how the value of your house as well as your debt can and should be integrated into your overall approach to managing and maintaining your financial health after you stop working and enter the “decumulation” phase of life.
Saving for Retirement – Looking at Debt and Real Estate from a New Perspective
Almost all Financial Planners pay some attention to an individual’s credit card debt, and some have even made a career out of telling people to “pay it off and tear it up”. It’s pretty hard to argue with this statement as, in concept, the advice makes sense. After all much of that debt likely arose from “over-consuming” and with interest rates on credit cards generally in the low to mid double digits, a level that is higher than most people’s personal rates of discount, the argument for using current income to pay off that debt and not accumulating more is pretty compelling. But I think just focusing on credit card debt misses the bigger picture.
There are all kinds of debt, and A LOT of it. When Financial Planners (and more than a few retirement consultants) say “get rid of credit card debt and start saving for retirement” what they are really saying is (with the exception of your Visa and Mastercard balances) “ignore your liabilities and increase your assets”. But does that make sense? Well let’s look at some numbers
The reality is that personal debt (i.e. student loans, auto loans, outstanding mortgage debt and credit card balances) is consuming the attention of most people and for good reason. In the aggregate, the amount of debt on individual balance sheets is greater than retirement savings assets and for many people it is much greater. To put it in context, total 401(k) assets in 2013 were about $4.5 trillion. The amount of outstanding student loan debt in that year was over $1 trillion while outstanding mortgage debt was $7.4 trillion and when credit card and auto loans are added in the total amount of debt burdening individuals is close to $10 trillion, an amount that is significantly more than all the retirement savings that individuals have set aside for their retirement years.
But let’s look a little more closely at some of that debt. Other than credit cards, most of that $10 trillion in debt is being used by people to obtain tangible assets (e.g. a house, a car or an education) that will generate some benefit (often but not always monetary) in the future. I would argue that not only were some of those decisions correct from a Present Value perspective (taking due regard of the personal rates of discount of those making the decisions ), but going forward it might actually make sense for many people to take on more debt rather than blindly following the conventional wisdom espoused by the financial planning community and the media in general to “increase your 401(k) contributions and save more for retirement”. This could very likely be the case if the choice is between an increased 401(k) contribution (particularly if there is no Company match involved) and buying a house with its inevitably higher (than rent) mortgage payments, but it could also be true when other types of loans are considered. For example, even the purchase of a new car, with the attendant increase in flexibility and/or reliability of the transportation might expand your ability and options for future income (and pleasure) sufficiently to make the purchase make sense. Investing in your education (where you might have to take out student and other loans ) to pay the tuition and make up for lack of current income is another prime example.
In fact, I believe that taking on debt and foregoing a long term benefit ( e.g. the ability to retire at an early age) for a current asset (e.g. a car) and a future short/medium benefit is the right choice far more often than most financial planners would like to admit, and this is particularly true when the individual honestly and clearly factors in his/her personal rate of discount into the consideration.
Before we talk about incorporating your real estate and debt into your short and long term investment strategy there is another aspect of debt that is well worth considering and that is how high the “quality” of your debt is. It turns out that individual debt is “rated “ just like the corporate and municipal bonds that you can invest your assets in For example, just as (low rated) corporate “junk” bonds yield a high interest rate and may have a place in your investment portfolio, the interest rate that you will pay on a lot of the debt that you take out is based on your credit rating (i.e FICO score). Therefore, one way to minimize the cost of your debt and enhance your financial wellness is to improve your FICO score. The factors and behaviors affecting an individual’s credit rating are complex, but by no means intractable, and just like exercise and good eating habits promote physical well-being, a “fiscal fitness” programs can enhance your financial health as well.
Putting It All Together
You may be saying that even if the above is true, once I have improved my FICO score and taken on the amount and kind of debt that makes sense for me, shouldn’t my focus on an ongoing basis still be on saving for retirement and investing those assets wisely? I would suggest that while savings and investing those savings for retirement are certainly worthwhile (I am an actuary after all), I believe that your debt and the value of your house (something that many people don’t think of as a “retirement savings” vehicle) should also play an integral part in the development of your overall asset allocation and the investment strategy that you employ. This is part of what I mean when I say that you should take a holistic approach to financial health.
Before considering overall investment strategy, the first and most important thing is to understand your debt as an “investment”. Even though it is a liability, from an investment perspective, you should think of it as another “asset class”, only in this case it is one that acts like a “negative bond”. Just like regular bonds that reside in your 401(k) account, your debt has a “yield” (the interest rate it costs) and a “duration” (when it needs to be paid off). And just like the very sophisticated “bond management” and asset allocation strategies that your Financial Planner may have discussed with you, I would argue that managing your debt to minimize its cost and the “mismatch” it might have with your assets and future cash flow is a worthwhile exercise that can have a big impact on your financial health.
I would also argue from a theoretical (and practical) perspective that you should consider your debt (as well as your home equity) as part of your total portfolio of “investable funds” when developing a long term asset allocation strategy. Doing so might, for example, cause you to significantly increase your traditional bond holding (to offset the “negative bonds” you already own) and/or stay away from any real estate investments beyond your primary residence (to maintain diversification). Here is where an expert who understands (and can explain) concepts like asset diversification as well as “yield curve”, fixed and variable interest rates, pre-payment penalties, etc can help you truly optimize the long term future outlook of your entire financial world.
In my next post we will shift our attention to how to maintain financial health throughout the “decumulation” phase of life. This is a very challenging problem that many of the best actuarial minds in the country are thinking about. In that post, I will try and give you a sense of the “state of the art” and share a few thoughts on how important a holistic approach is here as well. I will also discuss some of the many new financial tools being developed to aid you in that effort and give my views on some of the more exciting of them, including “longevity insurance”, Charitable Gift Annuities, and reverse mortgages that can be used to convert your home equity into a stream of income that can play a critical role in making sure that your financial health remains intact as least as long as your physical health endures.