Longevity risk is the risk that you will run out of money before your life ends. Longevity risk is assumed entirely by the client of the financial advisor. Career risk is the risk that an advisor will manage money in a way that does not meet client expectations and/or the internal expectations of their employer (often, maximize assets under management), causing the advisor to lose business and/or income for advisor/employer and/or otherwise damage the advisor’s career. Career risk impacts both clients and advisors.
Longevity risk is one of the primary reasons people seek advice with their financial plans. Extrapolating today’s savings into a spending plan 25+ years in the future is neither simple nor certain. As technology advances, we gain more complex tools to try to forecast possibilities, but these tools really do nothing in terms of making the future any more solid or certain. They just help us to quantify the possibilities, and (we hope) improve our decision making today.
A standard theory of economics is the Efficient Market Hypothesis (EMH), which contends that higher returns are accompanied by higher risk or volatility. Now, EMH has been disproven repeatedly, so that statement is not strictly true. However, the exceptions seem to be mainly transitory in nature (notably, value and momentum continue to persist as exceptions to the EMH rule). As an example, on average, stocks have higher returns and risk than bonds, and emerging market stocks have higher risks and returns than US large cap stocks. Another important fact is that any given asset, or asset class, or market can experience extended periods of unexpected performance, which I would define as generating a return different than expected given its risk. These are the exceptions to EMH. “Extended periods” have historically been up to 30 years! John Maynard Keynes is credited with the saying “The market can stay irrational longer than you can remain solvent.” This is one of the reasons that advisors use portfolios of diversified assets. These facts, along with client needs and circumstances, should drive all asset allocation.
We view the job of the advisor as having several vital functions. There must be a planning step, where the amount of money needed to retire with an acceptable estimated longevity risk is determined. This amount of money hopefully does not require the client to scrimp and save every penny possible along the way, but to enjoy life and spend some money today with an expectation of also enjoying life and spending some money in the future. Not all today, or all in the future. This step is the first one that butts up against career risk. In order to best serve the employer (broker/dealer, insurance company, etc.), anyone who is not a fiduciary will have incentive to maximize the amount saved now to the detriment of the client’s current budget. This is also a conflict of interest even for the fiduciary planner whose fee-only income is based on assets under management. Be sure to verify with your advisor that the planning process considers your current lifestyle, as well as the needs for non-investment planning assets like life insurance and long term care insurance.
The next step is selection of asset allocation. The SEC has rules about this, which is a second source of career risk. The amount that needs to be saved depends directly on the risk assumed in the portfolio. The client must understand and accept the risk in the portfolio that goes along with their current and future spending and savings plan. If an advisor selects a portfolio according to any industry “rule of thumb,” then the SEC will not be critical. However, if a plan that is more risky is selected, the advisor needs to be ready to defend their choices to the government. This is scary and potentially costly to the advisor and their employer, which will in general encourage the advisor to recommend less risky allocations (this dovetails nicely with the first source of career risk as well, by requiring higher savings to meet the same goals). Career risk is also impacted here by the teaching skills of the advisor. It is possible for people to enthusiastically accept different levels of risk than they might initially present as their ideal, if they are given all the facts about what those levels of risk mean for their current and future spending plans, and the possibilities for their portfolio performance.
The final step is ongoing maintenance of the plan. Nearly every investment asset is at risk of loss of capital, and almost all investors experience this pain at some point. If the advisor has adequately educated the client about the frequency and severity of drawdowns that are expected with their chosen portfolio, then any down cycles might be viewed as opportunities for additional investment rather than only as inevitable pain to be endured. Longevity risk and career risk coincide here. If the client stops following the investment plan, either by selling when values are low, or by failing to make planned contributions during a drawdown, then they risk not meeting their goals. The advisor experiences career risk from losing clients, and in some environments career risk can come with the drawdown itself reducing assets under management. In our view this is a failure on the advisor’s part, not from the assets behaving as they are expected to, but failing to either educate the client adequately, or failure to understand that the client, despite education, is not going to be able to tolerate the risks in a plan before the plan is implemented.
Additionally, the plan will undoubtedly need to change at some point. Life is full of unexpected changes. Your advisor should be able to help you modify your plan as needed.
How does this impact choice of advisor for those seeking financial advice?
- Be aware that any advisor who is not a fiduciary must account for career risk, and this is reflected (whether knowingly or not) in client portfolios, generally to the client’s detriment. Fiduciaries also have this risk, although it is slightly different and not as overbearing. Career risk will be highest for those who are working in a profit-focused environment (like big banks or insurance companies), and for those whose client base experiences high turnover. Be sure to ask any potential advisor about clients they have lost.
- Be aware that the default position of many advisors will be to maximize current contributions and use the most common or popular asset allocation strategies given the client’s number of years to retirement. This minimizes the amount of education that the advisor needs to do, and minimizes career risk. Be sure your advisor can explain why your portfolio is set up the way it is, and under what circumstances it would be set up differently. One warning sign of this is a portfolio with an equity allocation that is more than 50% US equities. Since the US market has been outperforming the rest of the world over the last few years, and clients are faced with US equity reporting at every turn, an advisor must work to educate clients as to why a global portfolio is generally the better choice (this may not be the case for every client or situation). This is called home bias, and believe me when I tell you that a booming US market is a fiduciary advisor’s second most difficult scenario, after the universal bear.