From Theory to Practice

Journal of Financial Planning: December 2019

 

 

Walt Woerheide, Ph.D., ChFC®, RICP®, is professor emeritus at The American College of Financial Services. He has held appointments as a professor of finance at the University of Illinois at Chicago, the University of Michigan–Flint, and Rochester Institute of Technology. He is a former president of the Academy of Financial Services. He has refereed articles for 16 different journals, including the Journal of Financial Planning, served on multiple program committees for professional associations, reviewed numerous textbooks, and serves as an outside referee for promotion and tenure cases.

At the 2019 FPA Annual Conference in Minneapolis (October 16–18), nine traditional academic papers were selected via a blind peer review process for general presentation. Some of the papers remain works in progress, where the full vesions have not yet been published, providing conference attendees an opportunity to provide feedback and suggestions to the researchers.

The foci of these papers were to provide research-based suggestions to financial planners for improving their practices. This article is a summary of these papers and more importantly, the conclusions and implications of the research presented.

A Positive Psychology Intervention for Happiness, Financial Satisfaction, and Financial Self-Efficacy

by Sarah Asebedo, Martin Seay, Shane Enete, and Blake Gray

The goal of this research is to test if a positive psychological intervention called the “Three Good Things” when applied to the financial domain effectively increases happiness and financial satisfaction, resulting in increased financial self-efficacy (FSE), and ultimately a stronger intention to save, according to the Theory of Planned Behavior.

Research has suggested that positive emotions facilitate financial success. Financial success in this case is represented by three attributes: (1) higher income; (2) greater self-control; and (3) improved self-efficacy, where self-efficacy is a personal judgment of how well one executes courses of action required to deal with prospective situations. If this is true about positive emotions, then one way a financial planner might be able to help a client is to create or otherwise enhance the client’s sense of positive emotions. Techniques to do this might be what are called positive psychological interventions. The Three Good Things technique is for an individual to write down three good events each day for seven days, what caused them, and that person’s feelings about them.

In this research, the authors divided their subjects into four groups. The first group did the traditional Three Good Things recordings. The second group was restricted to recording Three Good Financial Things. The third group was instructed to simply record Three Financial Things. The final group was the control group. The recordings lasted for seven days. The authors then surveyed the participants after each day, the day after the last day, and 30 days later.

The first goal was to see if these recordings led to heightened positive emotions (i.e., greater happiness and financial satisfaction), and if so, whether the groups that focused only on financial issues had the most improvement. The second goal was to see if the increases in financial self-efficacy were associated with the magnitude of increases in positive emotions. The results were based on the reports of 400 participants.

Statistical analysis of the various scores indicated that the Three Good Financial Things group and the Three Good Things traditional group consistently received similar happiness benefits. However, the Three Good Financial Things group had significantly higher financial satisfaction than all groups on most days, although the Three Financial Things group was close on this metric. More importantly, the positive emotional boost from the Three Good Financial Things intervention had a positive effect on financial self-efficacy.

What are the implications for financial planners? A financial planner might consider having clients regularly write down three financial events, identify what caused them, and note the client’s feelings about them. This may well improve the client’s financial satisfaction and happiness, and may ultimately influence the client’s financial behavior through stronger financial self-efficacy.

Aging and Loneliness: How Can Financial Advisers Help?

by Philip Gibson, Jimmy Cheng, Tao Guo, and Janine Sam

A trend developing in the financial planning field is that practitioners can best help their clients by looking beyond just investment management and the associated fields of retirement planning, estate planning, tax planning, insurance planning, etc. This research suggests that one such area is to help clients deal with social isolation and loneliness.

Although these two are related, social isolation refers to being physically separated, while loneliness is the subjective state of feeling alone. As people age, and particularly when they retire, they are at increased risk of both social isolation and loneliness.

Social isolation and loneliness are documented factors in health issues such as strokes, cancer, diabetes, and breast cancer, as well as coronary artery bypass surgery survival rates. Social isolation also seems to be related to faster cognitive decline, and recent research has shown that cognitive decline affects one’s ability to manage money effectively.

Helping clients avoid social isolation can certainly be an important component in financial planning, to the extent that it might lead to lower long-term care costs and reduce the risk of the client not being able to make sound financial decisions. The two goals of this study are to determine if individuals who work with a financial planner feel less isolated and lonely, and to explore steps a financial planner can take to reduce the feeling of social isolation and loneliness to ensure clients feel a sense of purpose during retirement.

The obvious assumption is that there would be a monotonically increasing relationship between age and the feeling of loneliness. After all, with age comes the loss of the company of work colleagues upon retirement, reduced social activities as one loses the ability to get around, and the deaths of friends and family. However, this simple relationship was not borne out by the statistical analysis. What did have a significant impact was losing a child, and more significantly, losing a spouse.

The study created a measure of a person’s sense of purpose. It turns out that the greater the sense of purpose, the lower the feeling of being socially isolated. Also, as expected, such activities as exercising, volunteering, traveling, and other traditional activities also lowered the feeling of being socially isolated. However, it appears that working with a financial professional and agreeing to share information with family members, friends, or others is not associated with a reduction in loneliness.

Finally, the study looked at the relative impact on social isolation of having an additional $100,000 in net worth versus evidence that an individual is engaging in social activities. The results suggest that the social activities had 19 times the impact on reducing loneliness than did the additional net worth.

What are the implications for financial planners? This research suggests that financial planners who stop their financial planning process with just the technical component of recommendations for investing, estate planning, tax planning, insurance planning, etc., are doing their clients a disservice. They should also consider delving into their clients’ social activities. Such questioning might serve a dual purpose of creating better bonding with the client by showing more personal interest, as well as identifying clients who are putting themselves at risk due to a lack of social networking activities.

A Comparison Study of Individual Retirement Income Bucket Strategies

by Tao Guo, Jimmy Cheng, and Harold Evensky

For retirement income planning, some financial planners propose bucket strategies. The term “bucket strategy,” however, is a generic concept in that there are a nearly unlimited number of bucket strategies one could create. This study identified three distinct bucket strategies and then compared their performance over time in terms of sustainable monthly spending, tail risk, behavioral benefit, tolerance of sequence risk, and tolerance of transaction cost.

The performance was based on a specific case scenario. To facilitate these comparisons, a benchmark strategy was also analyzed, wherein this strategy was like the application of a sustainable withdrawal rate. Monte Carlo simulations were used to test the different strategies.

The first bucket strategy evaluated was labeled the cash flow reserve strategy. This strategy employs two buckets. The first is a one-year cash reserve bucket, and the second is a traditional 60/40 stock/bond portfolio allocation. Monthly expenses were paid out of the cash bucket, which in turn was replenished in any of several ways.

The second bucket strategy evaluated was labeled a time bucket strategy. In this evaluation, there were three buckets. The first was to fund expenses for the first five years. The second was to fund expenses for the second five years, and the third to fund expenses for the rest of the investor’s life. The first bucket was all bonds, the last was all equities, and the middle bucket was a stock-bond mix.

The third strategy was labeled a goal-based strategy. In this case, specific goals and associated amounts for these goals were defined. The asset allocation depended on length of time until the funds were needed. The bulk of the investments were in the retirement bucket, which had a 60/40 stock/bond allocation.

It turns out that given the differences in the risk-return characteristics of the asset allocations, as well as the differences in how the withdrawals were managed and the buckets rebalanced, different strategies will be prefered depending on the criterion selected to evaluate their performances. If the goal is the highest sustainable monthly spending, then the time bucket strategy performs best. If the goal is to minimize the financial plan’s tail risk, then again, the time bucket strategy is best, as it achieves the least bad deficits in the worst-case scenarios. If the goal is to maximize behavioral benefits, then the time bucket and goal strategies are both better. With respect to tolerance for sequence risk, they all perform well except the time bucket strategy. Finally, regarding tolerance of transaction costs, all perform well except for the cash reserve bucket.

What are the implications for financial planners? First, the term “bucket strategy” is clearly a generic term, as there are many different such strategies. In addition, a portfolio may be managed in a multitude of ways within each category of bucket strategies. Based on these results and analysis, it is clear that a one-size-fits-all approach to selecting a bucket strategy would not serve all clients equally well. The financial planner needs to understand the risk tolerance and self-discipline that define each client before recommending a bucket strategy.

What Investors Value and What Advisers Think Investors Value: Identifying the Gaps Between the Two

by Samantha Lamas, Ryan O. Murphy, and Ray Sin

In any business, success depends on understanding what the customer wants and delivering that good or service. Financial planning is no different. This research has two parts. The first part analyzed whether financial planners truly understand what services clients are seeking from them. The second part looked at how one specific service might be better communicated. The goal is to build a better shared understanding of what creates value in financial planning.

To define what clients might be seeking from financial planners, a list of 15 services a financial planner would be perceived as providing was given to a large sample of consumers, and they were asked to rank them in order of importance. The same list was given to a large sample of financial advisers, and they were asked to rank how they think their clients would rank them; not how they think the list should be ranked.

The correlation between the two rank orderings was weak, although there was some congruence. Clients gave the highest rating to “helps me reach my financial goals,” and advisers rated this as No. 2. Conversely, advisers rated “uses up-to-date technology” as last, and clients rated this next to last.

Three of the items with the biggest mismatches included the following:

  • “can help me maximize my returns” was rated as fourth highest by clients and 14th by advisers

  • “understands me and my unique needs” was the top-rated attribute by advisers, but clients rated this as seventh

  • “is knowledgeable on tax consequences of investing” was rated sixth by clients and 12th by advisers

The specific item of concern in this research is the attribute: “helps me stay in control of my emotions.” Investors ranked this dead last, while advisers placed it more in the middle (11th). This disparity is then the basis for the second part of this research. That is: is it possible that the wording of this statement may carry negative connotations, such as being pedantic or paternalistic? To assess the impact of the wording, participants were divided into five groups with each group given a different set of wordings for this concept. It turns out that the choice of wording does matter. Of the five choices, the most receptive one was “helps protect my portfolio from excessive emotional reactions (panic-selling during downturns).” Two other alternative wordings that did well were “helps me avoid common behavioral mistakes,” and “helps me make decisions with a cool head.”

What are the implications for financial planners? The good news is, first, that there is a moderate alignment between investors’ preferences and advisers’ predictions about investors’ preferences. In addition, we can simply state that goals matter. But it is also noted that personalization is under-appreciated by investors. Investors gave high ratings to both “reach goals” and “maximize returns.” It appears that behavioral coaching is vastly under-appreciated by clients. Finally, clients are much more interested in tax advice and guidance than advisers are giving them credit for.

New Lessons About 529s: What’s Left on the Table?

by Steve Wendel and Michael Leung

Sending children and grandchildren to college is expensive! The authorization of 529 savings plans has created a way for clients to save for this expense in a more tax-efficient manner. However, many people do not utilize these plans. This research looked at two aspects of this problem. The first estimated the opportunity cost of not using a 529 plan. The second looked at techniques that might be used to increase utilization of these plans.

To estimate the opportunity cost, familial information was drawn from a couple of databases. Then, working only with monies that were set aside by these families for college, an estimate was made as to what returns could have been achieved if the families had used a 529 plan instead of the actual vehicles used. These calculations incorporated all the relevant tax rates, state tax benefits, and limits on annual contributions. The numbers were inflation adjusted.

Although the aggregate opportunity cost is huge, $237 billion by the time the children started college, this works out to an average of $4,044 per child. Lower-income families generally didn’t save much for college. The highest benefit went to families earning between $75,000 and $100,000 per year.

In the second part of the study, participants were asked which investment vehicles they were familiar with for saving for college. They were then asked how much they planned to save in 2019 and to specify an asset allocation. Next, they were divided into four groups for additional information. The first was advised about the growing cost of college. The second was advised of the benefits and drawbacks of 529 plans. The third was shown a comparison of the financial benefits of 529 plans versus other ways of saving. The final group was shown how to sign up for a 529 plan. The participants were then given a chance to revise their asset allocations. The focus was on the average percentage change in their allocation to a 529 plan.

The results showed that providing information about the rising costs of college and how to sign up for a 529 plan had little impact. However, information about the benefits of 529s and how the investment results would be improved both produced statistically significant increases in 529 allocations.

What are the implications for financial planners? First, the average family would receive a $4,044 benefit from utilizing 529 plans, and it is the middle-income clients who would likely benefit most from using these plans. Second, information overload and the complexity of figuring the actual costs and benefits may be too much for many of these families. Thus, simple presentations of the benefits and drawbacks, along with a clear presentation of the opportunity cost of not using a 529 would seem to be effective in nudging parents to increase the use of these plans.

Examining the Gender Pay Gap Among Financial Planning Professionals: A Blinder-Oaxaca Decomposition

by Derek Tharp, Meghaan Lurtz, Katherine S. Mielitz, Michael Kitces, and D. Allen Ammerman

In the U.S., there is an overall gender pay gap, and in many professions, there are also gender pay gaps. The field of financial planning is reported as having one of the larger pay gaps based on gender. Women advisers earn an average of 59 cents for every dollar earned by male advisers. However, this broad stroke statistic can be misleading when it overlooks specific job skills, responsibilities, and specialization, as well as age, education, work experience, and even something as simple as average hours worked. This research explored these contributing factors to see how much of this earnings differential they explain. Similar studies have found that anywhere from 89 percent to 93 percent of the gender pay gap could be explained by looking at individual characteristics of the workers.

For the database used in this study, the unadjusted gender pay gap was 19 percent. The variables that explained the largest portions of the pay gap in order were degree of motivation by performance pay, revenue production, and team structure. Other factors that helped explain the pay gap included role, degree of motivation by income potential, and degree of motivation by stable pay. Several of these factors together may represent one simple aspect of compensation. Some people prefer variable revenue-based compensation, and others prefer stable, salary-based compensation.

When all the variables available were incorporated into the analysis, the researchers were able to explain 91 percent of the pay differential, which left an unexplained pay differential of 1.8 percent. As with any such study, there is always some variation that remains unexplained. In this case, the explanation for the unexplained variation fell into one of two realms. Either there are other explanatory variables for which data were not available, or there may be some residual bias in pay by gender. However, it should also be noted that some of these variables that explain pay differentials may themselves be the result of discrimination. For example, women may not be given as much responsibility as their male counterparts.

What are the implications for financial planners? The significant implication is simple and important. If there is gender-based pay discrimination in the financial planning profession, it appears to be minimal and far less than that of other professions. Given that the financial planning profession is putting a substantial effort into bringing more women and minorities into the field, it is important to be able to point out that there appears to be little to no gender pay gap in this profession.

What Is the Most Tax-Efficient Way to Donate to Charity?

by Greg Geisler

Many older people like to donate to charities. But the desire to donate to help others should not preclude it being done in a way that is prudent with respect to taxation. There are three ways to be tax efficient: (1) give appreciated securities to a charity; (2) bunch itemized deductions (e.g., a contribution to a donor advised fund) provided the accumulated total exceeds the standard deduction; and (3) make a qualified charitable distribution (QCD).

Gifts to charity allow avoidance of the long-term capital gains tax and saves taxes to the extent the standard deduction is exceeded. To benefit from the donation of securities, a person needs to be able to itemize and/or their taxable income needs to be above certain thresholds. Bunching multiple years’ worth of charitable contributions into one year will substantially increase the benefit of tax savings from said itemized deductions. However, the bunching of deductions is of value only to the extent the total exceeds the standard deduction. The QCD will always save taxes, as this income is excluded from the calculation of one’s taxable income.

For comparison purposes, donating appreciated securities, especially if the total value is based on a bunching of future donations, will always be of greater or equal tax efficiency than just bunching future cash contributions into one year. However, a comparison of the tax efficiency of donating appreciated securities as compared to a QCD is much more complicated. This is because the relative benefits depend on three factors:

  • The extent to which the value
    of the bunched donation exceeds one’s standard deduction.

  • The taxpayer’s long-term capital gains tax rate.

  • The extent to which the taxpayer
    is in the tax torpedo.

For example, the QCD is the more efficient method if the taxpayer does not itemize. More importantly, the QCD is better if the long-term capital gain tax rate is zero for the donor, or if the taxpayer is in the tax torpedo. The one other scenario that would make the QCD the better choice is if the taxpayer intends to never sell the appreciated securities, which would allow them to be inherited without recognition of the long-term capital gain tax.

On the flip side, donating appreciated securities is more efficient if the taxpayer’s long-term capital gain tax rate is 15 percent or more and all the maximum amount of Social Security income is taxable. However, the exception to this case might be if a QCD would result in a lower Medicare premium and/or reduce the surtax tax on investment income.

These conditions mean there will be a middle ground where either might be the more tax efficient technique. One is that itemized deductions exceed the standard deduction before the charitable donation, and the long-term capital gain tax rate is at least 15 percent, and the taxpayer is in the Social Security tax torpedo range. The other is that itemized deductions exceed the standard deduction only after the charitable donation, the long-term capital gain tax rate is at least 15 percent, and the maximum Social Security benefits are included in income. (Editor’s note: the full, peer-reviewed version of this paper appears in this issue of the Journal, click HERE.)

What are the implications for financial planners? For low-income taxpayers with simple returns, the QCD is a virtually automatic choice for charitable donations. However, when the donation begins to move the taxpayer above the standard deduction, when the securities are highly appreciated, when the taxpayer may be subject to higher Medicare premiums, or when the taxpayer has substantial investment income, the choice is not obvious and requires careful consideration by the financial planner.

Are Optimistic Investors Smarter and Alone?

by Andrew Scott, Shane Enete, Wendy Usrey, Miranda Reiter, and Martin Seay

Investors differ in terms of their optimism about the overall market and about the performance of their own portfolios. This study examines some of the characteristics that distinguish the optimists from those who are not so optimistic.

The characteristics that were examined include: using a broker for financial advice; objective investment knowledge; subjective financial knowledge; formal financial education; and investment comfort levels.

One of the key results was that acquiring investment assistance from a broker increased the investor’s optimism about the market’s performance. Surprisingly, broker assistance did not seem to be related to the investor’s expectations of his or her portfolio performance. Next, lower objective investment knowledge was associated with more optimism about the market, but like broker assistance, was not related to portfolio expectations. Higher subjective financial knowledge not only increased the likelihood of an investor being optimistic about the market, it was also associated with the investor being more optimistic about portfolio performance. In contrast to the first three characteristics, neither formal financial education nor investment comfort were associated with the level of optimism about the overall market or one’s own portfolio.

What are the implications for financial planners? The authors suggest that because those investors who used brokers for financial advice had inflated expectations about the market, that brokers—and financial planners—should spend more time educating their clients about business cycles and historical market performance. Similarly, because investors with low objective investment knowledge and those with high subjective financial knowledge were also optimistic, they should also receive more education from their planners about basic investment products, trading strategies, and portfolio performance measurement.

Asset Location with Annuities

by David Blanchett and Michael Finke

Many retirees should consider an annuity as part of their retirement portfolio. The real question is whether the annuity should be purchased in a non-qualified account or a qualified account such as a 401(k) or an IRA. In 2017, the purchases of annuities in IRAs and defined contribution plans easily exceeded the purchases in non-qualified accounts. Government policy has encouraged the purchase of annuities within qualified plans by, among other actions, the Treasury approving the creation of Qualified Lifetime Annuity Contracts.

Purchase within a non-qualified account has the advantage of the exclusion ratio and the fact that taxation of investment gains is spread out over the life of the annuity. Purchase within a qualified account carries the intuitive appeal that one is using money set aside for retirement to fund retirement income.

This paper analyzed the potential benefit of purchasing an immediate and deferred annuity from different account types for various payout levels, tax rates, portfolio efficiency levels, and assumed portfolio rates of return. The results indicate that under most reasonable circumstances, a consumer is better off to purchase the annuity with non-qualified assets.

In general, using the non-qualified account becomes increasingly advantageous at higher tax rates, higher returns, higher gain realization rates, and lower payout levels. Specifically, the purchase with non-qualified assets becomes more attractive in all cases, as the nominal rates of return on the assets increase. Most of the time, using non-qualified assets is better as the investor’s marginal tax rate goes up. The exception here is when the higher marginal tax rates are combined with the lowest nominal returns.

What are the implications for financial planners? These results suggest that most people are probably purchasing their annuities in the wrong account. Even at modest rates of return, investors can gain substantive benefits by making the purchase with non-qualified accounts. Even better, investors in the highest marginal tax brackets can gain huge benefits even at modest rates of return if they purchase the annuity with non-qualified assets.

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And the Winners Are ….

The research presentations at the FPA Annual Conference were judged onsite by the Journal of Financial Planning editorial team, and two cash prizes of $500 were awarded for the best research presented at the conference. This year, those prizes went to Samantha Lamas and her co-authors at Morningstar for “What Investors Value and What Advisers Think Investors Value: Identifying the Gaps Between the Two,” and Andrew Scott from St. Mary’s University of Minnesota and his four co-authors for “Are Optimistic Investors Smarter and Alone?”

Call for Papers to be presented at the 2020 FPA Annual Conference (Sept. 30–Oct. 2) in Phoenix opens February 1, 2020. Email​ to learn more.

 

Topic
General Financial Planning Principles