Estate Planning Essentials: Preparing for the Unpleasantly Possible
As I mentioned in my missive from two weeks ago about the power of dividend reinvestment, I attended the Morningstar Investment Conference earlier this summer and heard from all kinds of mutual fund managers and investment professionals. However, the presentation that had the biggest impact on me — which is to say, it depressed the bejeezers out of me — came from Harvard professor David Laibson. His main point: From age 53 or so on, our cognitive skills begin to decline to the point where approximately half of people in their 80s suffer from some kind of impairment that could lead to significant financial mistakes. Recently, I grabbed a box of tissues and interviewed Dr. Laibson.
We all expect to slow down as we get older. However, your research indicates that the slowdown starts sooner than most people expect.
There are two types of intelligence that are particularly important.
- One is crystallized intelligence, which is accumulated through experience — think of wisdom, intuition, your familiarity with a set of problems that you have encountered many times. Crystallized intelligence rises over the entire life course; we keep getting better and better, but the rate of progress diminishes. We get better quickly as a young person, and then as we get older, the progress gets slower. Eventually we plateau, and maybe very late in life it declines. But mostly, it's progress.
- The other category is fluid intelligence, which is the capacity to confront a new problem and handle it very well. Fluid intelligence appears to peak around age 20 and then declines. When you put those two together, it looks as if we make the best decisions in mid-life — in our analysis, around age 53. Along with Sumit Agarwel, John Driscoll, and Xavier Gabaix, we find that the accumulation of wisdom and experience swamps the decline in fluid intelligence early in life. We are just getting better, even though our ability to solve novel problems is going down.
But around age 53, there is not a lot of additional crystallized intelligence year to year, while there is ongoing decline in fluid intelligence — so the decline in fluid intelligence ends up dominating. We peak around 53 and then start declining. That doesn't mean that we fall off a cliff at 53. But as you get out to the 70s and then particularly the 80s and 90s, the decline becomes sharper and stronger. Decision-making in the 80s and 90s is significantly impaired for many older adults.
Is there anything people can do about it — exercise, a good diet, anything like that?
Well, no, there is not a lot. Exercise and diet will reduce the odds of cognitive impairment a little bit, but those effects are modest. And so I think we shouldn't be focused on avoiding the possibility of cognitive impairment. We have to recognize that no matter what we do, the risks are significant and hence we have to prepare for that possibility rather than naively thinking we can somehow avoid that outcome.
At what age should people start factoring this into their financial and estate plans?
The second you form a family — even if you have modest assets — you should begin to prepare for this possibility. I say that because it is not just dementia that can be a problem. You can have a stroke in your 40s and not be in a position to make great decisions; you can get into a car accident and have a head injury. So the earlier, the better.
On the other hand, risks don't really pile up until the 70s, so if someone told me, “Look, I am just not too worried about these issues; I am 45 years old,” I would say, “I think you are making a mistake,” but I wouldn't get too agitated. For someone in their mid-60s, that is really when further delay is becoming irresponsible. By the time someone is in their mid-60s, there is no excuse for delaying the acquisition of the key legal documents that enable you to prepare for these transitions.
Those documents should include durable power of attorney, and would include — if you have significant assets — a living revocable trust as a way of protecting your assets, and would include, of course, a will. Then there are two health-care documents that are very important. There is a health-care proxy, which is the assignment of some person or set of people to make health-care decisions for you if you are incapacitated, and there is also a living will, which is a set of instructions to those individuals that expresses your preferences about the nature of medical care. If you are in an ICU, for example, what extreme measures should or should not be taken to prolong your life? Those are the five documents I strongly recommend that anyone who is part of a family have. By age 65, it is critical.
One of the solutions you propose is for older investors to buy income annuities, which provide income for as long as you live.
An annuity is such a wonderful way of addressing a lot of the risks that older adults face. Let me go through the benefits of an annuity, and then I want to acknowledge that most people don't want annuities, despite these benefits, so we can talk about that psychological resistance.
- The first big benefit is that it addresses longevity risk — in other words, the risk that you might outlive your assets. Here we are at age 70; we could live five years or 30 years or even 40 years, so that is a big risk. If you live a very long time, and you are spending down your wealth, you face the possibility that you will run out. An annuity eliminates that risk, because the annuity pays out as long as you survive. If it is a joint annuity — owned by you and your spouse — the annuity pays out until the second member of the unit dies. So it is a great way of insuring against the possibility of living too long. That is one benefit.
- Another benefit of an annuity is that it is very, very simple. The check comes every month in the mail. There is no need to worry about asset allocation. There is no need to worry about how much to spend, how much to save. The check comes, and that is your budget for the month. The chance of having some nasty person rip you off by getting you to invest in their harebrained scheme is reduced, because you don't have your personal wealth sitting in a checking account. Instead, the annuity company, in essence, is holding your personal wealth for you. So in all these ways, the annuity is protective. It protects you against longevity risk, it simplifies your decision making, and it protects you from bad actors and from mischief. Terrific.
So why don't people have annuities? Well, annuities, of course, have a bad name for many reasons. First of all, people perceive them as being complicated, and in some ways they are complicated legal documents, complicated financial contracts — particularly, a lot of the modern annuities have a lot of special clauses. People worry about fees with annuities, and it is true that the majority of annuity products are excessively expensive and not a good deal. And people like to have a sense of control; annuities mean passing control over to somebody else — in this case, the insurance company.
Now, I don't want to dictate to people and say, “You have to have an annuity.” I hope that people can weigh the pros and cons, particularly while they are still highly cognitively functioning in their 60s, and figure out what is right for them. I do think people should think seriously about annuities and look hard for an insurance company that offers highly competitive rates if they are going to proceed with an annuity. But if at the end of the day, you insist on controlling your assets, and you want full liquidity, then an annuity is not for you.
The one thing I would consider is a partial annuity. You still have some significant fraction of your wealth in your own hands. You can decide what to do with it, and it is there as a bequest in the event of your death. You can spend a lot or a little each year, you have flexibility. Then take some other fraction of your wealth and annuitize that. Now, we have the best of both worlds: You have got some control, but you also have a nice amount of longevity insurance in the form of a significant fraction of your wealth annuitized.
It also seems that you don't only have to worry and plan for your own possible cognitive decline but also for that of your spouse and maybe older relatives. Any advice on how to make protecting against age-induced financial mistakes a family affair? How do you broach that topic with older parents or other relatives who are getting up there in age?
I think the key thing is that people recognize that when we recommend these things, we are not recommending it because a particular parent is showing some kind of cognitive impairment; it is a recommendation that is universal. All people — regardless of their vitality, regardless of their cognitive function — should execute the five documents that I described a moment ago. It is just how responsible people behave, and so I think the messaging has to be, “It is not about you, Mom, or you, Dad. It is not any judgment that anyone is making about your mind or your thinking, it is just the normal course of affairs for everyone who has a family, and anyone who has an estate.”
How do you respond to someone who says, “Well, Berkshire Hathaway Chairman Warren Buffett is 80, and Vice Chairman Charlie Munger is 87, and they are still beating the market”?
It is not that everyone's fate is to have dementia at age 85; no one is saying that. What is being said is that the frequency of dementia increases with age to the point where one in five individuals in their 80s has dementia, and one in three individuals in their 80s has cognitive impairments that fall short of dementia. Put all that together, about half of people in their 80s have significant cognitive impairment. So half the population is going to be in a good position to make decisions and half is not. The problem is that you don't know which half you're going to fall into.