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.

Robert Brokamp
We all expect to slow down as we get older. However, your research indicates that the slowdown starts sooner than most people expect.

David Laibson
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.

Robert Brokamp
Is there anything people can do about it — exercise, a good diet, anything like that?

David Laibson
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.

Robert Brokamp
At what age should people start factoring this into their financial and estate plans?

David Laibson
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.

Robert Brokamp
One of the solutions you propose is for older investors to buy income annuities, which provide income for as long as you live.

David Laibson
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.

Robert Brokamp
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?

David Laibson
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.”

Robert Brokamp
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”?

David Laibson
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.

Further reading: For more from David Laibson, check out this interview with Morningstar's Christine Benz or this PowerPoint presentation from Laibson (click on “The Age of Reason”).
More about...Planning, Investing, Retirement

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SB(One Cent At A Time)
SB(One Cent At A Time)
9 years ago

isn’t that scary to even think you will most likely loose abilities as we age beyond 53?

Holly
Holly
9 years ago

It’s scary that people are always forgetting how to spell ‘lose’, lol!

STRONGside
STRONGside
9 years ago

Regardless of whether or not dementia or cognitive reasoning abilities set in when I reach 75 or 80, I just don’t think I want to worry about money at that point. If my investment and retirement vehicles are functioning as they should, I should be free to spend time enjoying my family and the time remaining to me.

Mike Holman
Mike Holman
9 years ago

Great article – losing financial brain power in my old age is something that concerns me.

I think annuities are a great product, but I suspect one of the big reasons people don’t buy them is because they are afraid of “losing the bet” if they don’t live that long after purchasing.

Ironically, a lot of those same people are probably jealous of government workers with good pensions, but a good defined benefit pension is really just an annuity.

Alexandra
Alexandra
9 years ago

After my grandfather died over 30 years ago, my dad put all his mother’s money into an annuity, which suited her personality just fine as she lived frugally and did not want to have to think about money matters.

She died last month…at the ripe old age of 96. If she had NOT had the annuity, we would have had difficulty providing the level of care she received as her health declined over the years.

I say an annuity is a great bet…and if you lose it, who cares? You’re dead!

Annemarie
Annemarie
9 years ago

An annuity was recommended for us and we turned it down. This was just after AIG almost crashed, and we were concerned that the company (Transamerica) might disappear, or that nobody would show up to bail it out if there were problems. Plus we were concerned about extremely expensive illnesses — my parents’ medical bills were running around $120k a year for the last five years before they died, and thank God they were good savers — and we wanted our capital available if/when this happens to us. Keeping an eye on a parent’s checkbook is a useful thing. One… Read more »

Chad
Chad
9 years ago

This was a fascinating article until we got to the annuity section. That’s when the author, Dr. Laibson, and entire article lost it’s credibility. The title of the article should have said something along the lines of “Estate Planning Essentials: Annunities as a Way of Preparing for the Unpleasantly Possible”.
Let’s be honest. It was really an article to get folks to consider annuities.
JD, please reign in your outsourced help.

chacha1
chacha1
9 years ago
Reply to  Chad

Completely disagree. Neither Brokamp nor Laibson said “everyone should have an annuity,” so there’s no question of losing credibility.

They both said annuities are not for everyone while at the same time saying it’s something many people don’t consider – but should.

Do you *want* financial planning information that leaves out important options? I sure don’t.

Also: its, not it’s
rein, not reign

Jen
Jen
9 years ago
Reply to  Chad

The take home I got from the annuity section was that it’s a good enough way to diversify in a different way — that is, that you’ll have a known chunk of money coming in for as long as you’re alive. I didn’t see anyone saying put everything you own into an annuity!

Marsha
Marsha
9 years ago

Age 53 seems to be so arbitrary as the age at which decline begins. And intelligence, whether “crystalized” or “fluid,” is incredibly hard to measure objectively. This is not to say that there are not observable cognitive problems in some elderly people.

Then again, maybe I’m just overly sensitive because I’m just a couple of years under the age of decline.

Rosa+Rugosa
Rosa+Rugosa
9 years ago
Reply to  Marsha

Hey, don’t feel bad. I am 53!

Adam P
Adam P
9 years ago

Wow 9 comments. I don’t think people want to talk about preparing for their own deaths or loss of their mental faculties, JD. And I can’t blame them. What’s the point of any of this if we’re just going to die anyway? It’s pretty depressing to contemplate the nothingness after death. When I think of retirement planning, I just want to think of not having to work anymore and what cruise line is en vogue that year on my trip to exotic destination #18. I don’t want to think about preparing for diapers, drooling, and durable power of attorney. (Which… Read more »

El Nerdo
El Nerdo
9 years ago
Reply to  Adam P

Yes, it’s a tough scenario to stomach. Useful read though.

Not that everyone will go senile at 53 of course– that’s just a statistical figure of some theoretical inflection point.

On the individual level, there are ways to keep your mind sharp, from the usual “exercise and good nutrition” prescription to avoiding routine and seeking new challenges.

Regardless, everyone gets sick and dies in the end. So this is a post I’ll keep in mind– at least until my mind goes :/

krantcents
krantcents
9 years ago

What you are asking us to do is plan for the unknown! I am near retirement (2nd time) and will receive Social Security and a pension. It is my “annuity” portion of my retirement. In addition, I have a IRA, Roth IRA and 403B which will add to my retirement. I also bought Long Term Care insurance for my wife and I.

RS
RS
9 years ago

What about advice for single people without children???

Catherine
Catherine
9 years ago
Reply to  RS

As a single person without children, I believe all of these items are even more important for people like us so that weird Uncle Harold who believes in cryogenics isn’t responsible for your health care. Then again, I’m over 53, so nothing I say matters.

RS
RS
9 years ago
Reply to  Catherine

Wow. Thanks for the pep talk. 🙂

Mike Holman
Mike Holman
9 years ago

@Marsha – I imagine age 53 is pretty arbitrary. Besides, the age where the decline starts is not as important as the age when the decline has reached the point where it is affecting your financial decisions. @Adam P – I think the post title is a bit misleading in that buying annuities or planning for your mental decline in old age isn’t really estate planning, which has to do with death. It probably should have been called “Later Stage Retirement Planning” or something like that. It also doesn’t mean dealing with drool – you may get to a point… Read more »

chacha1
chacha1
9 years ago

The material in the post may well be categorized as “Later Stage Retirement Planning” but it also bears directly on estates. Basically, if you don’t make plans specific to the later stages of retirement – i.e. the stages of mental and physical decline – you aren’t likely to HAVE an estate. Retirement planning has to include the stage of “just quit working, time to go play golf” as well as the stage of “can’t walk, hear or see anymore.” The point is that there is more to estate planning than writing up a will. And also that I am a… Read more »

fetu
fetu
9 years ago

My father in law, despite having been a good business man of some wealth, in his 80s gave most of his money away to a girlfriend with a gambling habit. We see enough stories of the elderly being duped on the TV news. My very bright Aunt in her 80s spent a lot of money buying Readers Digest books that kept coming in her mail, even though she did not order them, but felt that she now had to pay for them. This article is a good warning to us all…..statistics do not lie. We lie to ourselves saying it… Read more »

Dan M53
Dan M53
9 years ago

Three more good years, then it’s all downhill from there – Dang! Good thing I married a younger woman!!

Jen
Jen
9 years ago

**When you put those two together, it looks as if we make the best decisions in mid-life – in our analysis, around age 53. ** You know, this is a lot more positive spin on it than the later discussion of it. PEAKING at 53 means that you were less smart/cognitively with it at 52, and even less so at 51, etc. Imagine it as a lovely curve on a graph — you’re not dropping off a cliff, you’re only slowly declining to where you were in your forties and thirties… This was written in a more fear-mongering way than… Read more »

Kenny
Kenny
9 years ago

Regardless of age, the idea of doing the Asset Allocation, Will, Trust and also Annuities is just a great idea. It is what ALL good finance books write about.

There are too many comments above on age 53, but very few on talking about which annunities, or how to go about doing the trust (complex), also how to manage the partial assets (outside of annuities) and finally, the type of annuity that is best for us (there are so many types with the numerous riders).

KKP

Jerry
Jerry
9 years ago

Annuities are a good idea. They can lead to peace of mind for preparing for the future.

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