Friday, February 13, 2015

Aging and Financial Decision Making - How to Protect Yourself

In January, The Center for Retirement Research at Boston College released a report, How Does Aging Affect Financial Decision Making? The report raises significant concerns about the financial ability of older investors who are suffering declining cognition. (The term “cognition” refers to the mental activities involved in tasks like learning, remem­bering, problem-solving, and using knowledge).
It is probably to be expected that cognitive decline would result in a corresponding decline in financial literacy. To me, the report’s more telling conclusion is that an older investor’s cognitive decline has “essentially no effect on their confidence in managing their finances.” 
“[L]arge declines in cognition and financial literacy have little effect on an elderly individual’s confidence in their financial knowledge, and essentially no effect on their confidence in managing their finances. Individuals with declining cognition are more likely to get help with their finances. But the study finds that over half of all elderly individuals with significant declines in cognition get no help outside of a spouse. Given the increasing dependence of retirees on 401(k)/IRA savings, cognitive decline will likely have an increasingly significant adverse effect on the well-being of the elderly.”
This combination of declining ability with undiminished confidence seems to me to be a prescription for financial loss and an open door to fraud and financial abuse.

The Risk of Declining Investment Ability

David Laibson, professor of economics at Harvard University, has studied the subject of the impact of aging on investment ability.
Professor Laibson suggests that there are two categories of intelligence that are critical to investing: “fluid intelligence” – the creative ability to analyze new information and solve novel problems, and “crystallized intelligence” – the ability, through life experience, to accumulate knowledge that helps us solve familiar problems and become better investors.  
After we reach age 20, these intelligences start moving in opposite directions. Fluid intelligence begins to decline (before most of us will even have anything to invest) while our crystallized intelligence generally improves with experience and age. During our 50s, the decline in fluid intelligence becomes dominant and our overall ability to make sophisticated decisions begins a gentle decline.
So, for many of us the peak in our ability to make the best investment decisions is during our 50s.  By the time we’re in our 80s, our ability to make good decisions is significantly compromised, particularly decisions that involve complicated new problems (like evaluating a financial product with which we are unfamiliar).This is just normal aging.
In addition to normal aging some older adults will suffer a rapid deterioration in function due to a pathological process such as a stroke or Alzheimer’s. Dementia, such as Alzheimer’s, impacts every aspect of intelligence. Unfortunately, the risk of dementia doubles every five years that we age. By the time we reach our 80s, the likelihood of having relatively severe dementia is about 20%.
The risk of having significant cognitive decline that is not dementia (“cognitive impairment not dementia” or CIND) affects another 30% of people in their 80s.  This means, says Professor Laibson, that half of the 80 year old population should not be making important financial decisions.  
For more of Professor Laibson’s thinking see Aging and Investing: The Risk of Cognitive Impairment, Forbes, October 11, 2011.   
This is not to say that every older adult will suffer a global cognitive decline, or to deny that some decision-making processes might even be enhanced in many older adults. It is rather to suggest that older adults should address the significant risk that cognitive decline may impact their financial decision-making in ways they will fail to recognize.
If you are an older adult (like me), what should you do if you understand that there is a big risk that your financial ability will decline and you want to prepare for it? How can you protect yourself and your portfolio and your well-being from loss if your skill does eventually decline?  Although each of us surely ages differently, are their some general conclusions that can be drawn?

How Can We Protect Ourselves?

Because the risk of eventual cognitive impairment is so great, we should begin to prepare for it by the time we are in our 60s. Professor Laibson suggests that everyone should consult an estate planning attorney to discuss and execute several critically important legal documents.
On the financial side these documents include a will, a financial power of attorney, and possibly a trust. On the personal care side your lawyer can also help you create legal authority for appropriate health care decision making in the event your incapacity. Don’t wait until decline sets in to do this legal planning – it involves complicated and subtle decisions that are best made while you are at maximum competency. 
Psychological preparation for aging is also crucial. You need to come to terms with the reality that you are probably not going to be operating at as high a level of cognitive functioning over your entire life. If your family relationships are good, help prepare your family for this reality as well.  
Fraud and financial elder abuse are a growing problem. Organize your assets so that you don’t purchase investments that are inappropriate for you or end up being ripped off by con artists. As you age and your risk of cognitive decline increases you might consider setting up a trust and obtaining professional management and protection for your investment portfolio.
If you continue to invest on your own, recognize that your ability to analyze complicated new financial products will likely decline with age and stay away from them. Stick with less-likely-to-go-awry investments like diversified mutual funds with low fees. With this latter kind of investment you are basically delegating decision making to the mutual fund manager.  
Avoid the two big mistakes that many investors make as they age. The first mistake is to think that dementia won’t happen to them. Accept the reality that there is a significant chance that substantial cognitive decline will affect your life someday.  The second mistake is thinking that you will recognize cognitive decline when it occurs.  “That’s a grave mistake" says Professor Laibson. "We don’t have that ability to suddenly recognize it and do the right thing just before we lose the capacity to make these decisions well.” Don’t wait.  Be prepared in advance.  
Based on my experience as an elder law attorney, Professor Laibson is providing excellent advice. Every experienced elder law attorney can relate stories about clients who purchased wildly inappropriate investments they didn’t understand with resulting sad consequences. You can preserve your financial security through acceptance of the realities of aging and the potential for cognitive decline and by preparing well in advance. 
Acceptance and advance preparation may be the wisest investment of all. 

Further Reading: 

Investing and the Aging Brain: ‘What Do I Do When I Get Stupid?’

As Cognition Slips, Financial Skills Are Often the First to Go, New York Times, April 25, 2015

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