Lifetime Financial Advice: Enhanced Personalization by Considering Human Capital

A guest on this episode, Tom Idzorek, is an employee of Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc.

Tom Idzorek and Paul Kaplan—the guests on this episode—are recent authors of the book, Lifetime Financial Advice: A Personalized Optimal Multilevel Approach, which is freely available and can be accessed here:

https://rpc.cfainstitute.org/-/media/documents/article/rf-brief/lifetime-financial-advice.pdf

Nicholas VanDerSchie: The evolution of financial advice in a few decades time has been nothing short of revolutionary. The industry's transformation has been driven by technological advancements, regulatory changes and evolving investor preferences. Traditional methods of in-person advice have been expanded to include digital platforms, providing investors with greater accessibility and customization. And we've all observed an evolution in financial planning journeys and an increase in the number of advisors making financial planning core to their value proposition.

But we still have to ask, is there room for improvement? Today, we're joined by two guests who are co-authors of a new book titled Lifetime Financial Advice: A Personalized Optimal Multilevel Approach. First, Tom Idzorek, Chief Investment Officer, Retirement for Morningstar Investment Management. Amongst Tom's many responsibilities, he serves as a member of Morningstar's 401(k) Committee, Public Policy Council, Global Investment Committee and the editorial board of Morningstar Magazine. And also, Paul Kaplan, who is officially a Morningstar alumnus after his recent retirement. Prior to retirement, Paul was Director of Research for Morningstar Canada and a senior member of Morningstar's global research team, where he was instrumental in research on asset allocation, retirement income planning, portfolio construction and index methodologies. Their book recently underwent a soft launch in collaboration with the CFA Institute, and we're excited to discuss it with them today.

Hello, and welcome to Simple But Not Easy, a podcast from Morningstar's Wealth Group, where we turn complicated financial developments into actionable ideas. I'm Nick VanDerSchie, Head of Strategy and Execution for Morningstar Wealth and I'm excited to explore these topics with our guests today.

Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com.

Now, let's get started. Tom, Paul, welcome to Simple But Not Easy.

Paul Kaplan: Thank you. Glad to be here.

Thomas Idzorek: Yes, thanks for having us.

VanDerSchie: So, guys, your new book is called Lifetime Financial Advice: A Personalized Optimal Multilevel Approach. Congratulations on its release in collaboration with the CFA Institute. What inspired you to write it?

Kaplan: Well, the issues that we address in the book, I have actually been working on for quite a long time. I learned basically the principles of life cycle finance as a PhD student at Northwestern. And then throughout my career, I've been working on some things here and there with life cycle modeling. But eventually, at Morningstar, I had a column at Morningstar Magazine called Quant U. And in a number of those articles, I wrote about various aspects of life cycle finance. So, when Tom and I were putting this book together, a number of the chapters were originally articles in Morningstar Magazine, which we adopted to make it into a book.

Idzorek: And I might add, we have at Morningstar a series of offerings, of course, related to financial advice and financial planning. And it's part of our, at least my job, is working on these algorithms, these machines that are designed to provide optimal advice. And as Paul mentioned, I think we're both doing what I think is interesting research on the topic of how do you provide optimal advice to investors at scale. And I felt like we had something to say. There had been a precursor book that the CFA Institute Research Foundation also published around 10 years ago. And since that has been published, 10 years of new research has occurred, and a lot of that, as Paul mentioned, appeared in Morningstar Magazine. And I think we simply had something that we thought was worth adding to the body of knowledge.

VanDerSchie: So, Roger Ibbotson, Founder and former Chairman of Ibbotson Associates, wrote the forward in the book where he mentioned, Tom and Paul deserve a great deal of credit for providing a holistic set of solutions to some of the most important problems that we face in our lifetimes. That's high praise from a pioneer in our industry. Tom, maybe could you share a little bit about your relationship with Roger as well as Ibbotson Associates' history with Morningstar?

Idzorek: Absolutely. And I think you should also ask something similar of Paul because Paul worked for Ibbotson Associates, Roger's company, before I did, and then Paul ended up leaving Ibbotson Associates to join Morningstar. I worked at Ibbotson Associates when it was acquired by Morningstar in that – I think the transaction ended up closing in March of 2006. Oddly – well, of course, I would have interacted and known Roger at the time that he owned and ran Ibbotson Associates. But if anything, since Morningstar has acquired Ibbotson Associates that my relationship with Roger has actually become much closer.

Both Paul and I continue to do active research with Roger. We collaborated on another CFA Research Foundation book called Popularity along with Morningstar's co-worker, James Xiong. And then we've also collaborated on a number of papers. And this is, in my opinion, extremely interesting work and it's just a real gift to be able to work closely with somebody like Roger. I guess some of our conversations with Paul and Roger debating what we're writing about, the theory behind it, et cetera, they're just fantastic conversations, and it's just a real honor to get to work with somebody like Roger Ibbotson.

VanDerSchie: Paul, anything to add on your side?

Kaplan: Yes. So, I joined Ibbotson Associates back in 1988. The first time I met Roger is when he interviewed me for a position there. At the time that I joined, I was probably the 10th person there. So, we were a very small consulting firm. We were selling some software and data. And we were also working on various consulting projects, including providing expert witness testimony in rate setting cases. And Roger was the expert witness to that, but I and others assisted him in preparing his testimony. I actually got to be a witness myself in really two occasions.

So, I left Ibbotson Associates back in 1999. And before I left Ibbotson Associates, Roger and I had drafted a paper called The Importance of Asset – Does asset allocation explain 40, 90 or 100% of return? And that paper was published in the Financial Analysts Journal and was recognized – came out in 2000 and then was recognized as a significant paper, because we won a Graham and Dodd Award of Excellence, which was the second level award of the Graham and Dodd. So, of course, I knew Roger.

In 2006 Morningstar acquired Ibbotson Associates, and I saw Roger again for the first time after the hiatus of the time between I left Ibbotson and the time that Morningstar acquired his firm. And I think since then, we have been collaborating with Roger on some things. There's another CFA Institute publication, which Tom and I and Roger and another Morningstar author published at the CFA Institute on Popularity: A Bridge Between Classical and Behavioral Finance. So that was another very successful collaboration we had with Roger. And we've been working with him on the topic of popularity actually ever since then.

VanDerSchie: Tom, you mentioned the publication from 2007 and that's where Roger and his research partners also published on the topic of lifetime financial advice. In the decade plus since that release, obviously a lot has happened. Maybe before we jump into the new book, Paul, can you briefly talk about the contributions of that 2007 release?

Kaplan: Yes. So, the 2007 book brought together asset allocation and human capital. That was kind of one of the major contributions of it and actually anticipated what – in the new book, what Tom and I call the child model. It also integrated in life insurance and that. And then there was a section about annuities as well. So, it had some important contributions. However, it also had certain limitations. Number one, it was lacking really a comprehensive model to tie all these things together. It handled some of these issues somewhat separately. And number two, and I think most importantly, it did not model how much consumption investors should have over the course of their lifetimes. It took their consumption as given and instead it focused on wealth or what we call net worth.

So that was in the 2007 book. But we wanted to – when Tom and I were talking about writing this book, we did want to put it kind of under that banner of lifetime financial advice. Because our book does deal with some of the very same issues. But in our book, we use a comprehensive or holistic approach to the models, and we also, and I think most importantly, our models provide advice on how much should investors spend year in and year out as they approach retirement and after they're retired. So that I think was a very important contribution we made in this book relative to the previous book.

VanDerSchie: Great. So that's probably a pretty good segue. Let's jump into the meat of your new book again titled Lifetime Financial Advice: A Personalized Optimal Multilevel Approach. The first concept from the book that I want to ask you about is life cycle finance and the book states that life cycle finance is one of the most important specialties in finance. The concept embraces the critical role of human capital as arguably the most important asset for many investors. Can you walk us through what you mean by that?

Kaplan: Yeah. So by life cycle finance, what we mean by that is we need to develop the economic theory that's been developed – as we go as we say, going back to Irving Fisher in the 1930, the economist Irving Fisher, published a book where he talked about smoothing out your consumption over time, you should save before you retire and then and then spend down your portfolio after you're retired. And then there's been a huge amount of literature on this topic developing it further and further. Milton Friedman, Franco Modigliani, Paul Samuelson, Robert Merton. These are some of the main contributors to the field of life cycle finance. And the one thing that any life cycle finance model tells you is how much you should consume year in and year out over the course of your life. And we think that is absolutely essential. And it's an essential question and it needs to be answered in the context of all the other elements such as asset allocation, life insurance and annuities. Tom?

Idzorek: Well, maybe we want to touch a little bit more on kind of the role of human capital within your question, Nick. So human capital is for most people kind of a hidden asset. They're kind of unaware of its intrinsic value, if you will. But if you think about a young person as an example, most young people that I know have not saved up very much money, if any at all, they might even have student debt, for example. But if you think about their lifetime of future earnings, you can begin to estimate what is the net present value of a lifetime of earnings. And it is really this asset, this human capital asset that enables people to, one, to get a loan when they're young to maybe purchase a car, purchase a house or take on student debt, which I just mentioned. And so, they're able to consume even though they don't have many financial assets. And then, if you think about your paycheck, maybe through time, for most of us, especially when we're young, maybe 100%, but hopefully not quite 100%, maybe 95% of it goes out the door right away to pay for ongoing living expenses. But a small portion of that paycheck hopefully is saved so that when we reach retirement and we're no longer working, we'll be able to continue to consume at a relatively smooth level. And that's what lifecycle finance is about.

VanDerSchie: Thanks, Tom. The book mentions that a key element of delivering on lifetime financial advice is personalization. What do you guys think are some of the major impediments for financial advisors in achieving this on behalf of clients? Are the challenges technology related or is it something else?

Kaplan: I would say it's something else because I mean the technology can certainly always be built to address this. I would say, number one, the way risk tolerance is approached, where financial planners will use risk tolerance questionnaires to establish what's the attitude towards risk of the investor. The problem is that they apply that only to their financial wealth rather than what we call net worth. And net worth, it's not only financial assets, it's also human capital. And that is minus liabilities and by liabilities we mean the present discounted value of consumption you have to make, such as, food, shelter, clothing, so forth. So, number one is they're not getting risk tolerance right.

Number two is they're probably generally unaware of other preference parameters. In our model, we identify five distinct preferences in that. One is called the elasticity, the elasticity of intertemporal substitution, that is the willingness of people to substitute consumption in one period versus another, and includes their subjective discount rate, which is how impatient they are. And by impatience, what I mean is that how much do they have to – you can think of this way – suppose they're putting money in, say, a bank account, how much interest would they require to get in order to forego consumption today in order to get consumption in the future? That's a very essential parameter. It's actually one of the essential concepts in economics, which is the idea that people prefer things today versus tomorrow and how willing are they to make that trade-off.

And then the other two parameters are related to the question of how big should a bequest be, because I don't think there really is a way to come up with an ideal size of a bequest in current practice, where you just kind of work it out how much you should leave behind. So, it's measuring risk tolerance in the correct context, and it's also addressing the other parameters. And I know in chapter two, Tom developed some prototypical questions, maybe, that could be even asked investors to try to get to these other preferences.

VanDerSchie: Paul, I'm glad you…

Idzorek: Maybe before...

VanDerSchie: No, go ahead, Tom.

Idzorek: Backing up just a little bit, to me, I think the biggest issue is just awareness. And to me, it's a bit of a paradox that – Paul named some of them, I think there's over 11 different Nobel Prize winners have done work related to life cycle finance. And yet my belief is that most financial planners and financial advisors are perhaps only vaguely aware of, let's say, the concepts and techniques associated with life cycle finance. And so why are people unaware? Not entirely clear to me, but our investment textbooks have largely been, I'd say, unchanged over the last, say, 25, 30 years. They get updated maybe each year, but these updates are minor. And by and large, our textbooks and curriculums are not teaching what goes on within the school of economics and economic theory, and really life cycle finance is kind of the economists agreed upon, I'd say – or nearly agreed upon view of how financial planning should take place. And yet, again, it is not in our textbooks, it's not in our curriculum.

As may be an example, at Morningstar, we hire a number of PhDs and some of these PhDs have received their degree in financial planning. So, I get to talk with them and interact and work with them on a regular basis and by and large life cycle finance is still not really incorporated into the PhD programs on financial planning. And this is an oddity. And so, to me, how can advisors and practitioners be embracing something that is quite advanced yet they're unaware of it? And so again, to me, a call upon the industry is to, one, become aware of life cycle finance and then begin to have technology that would enable advisors and planners to use this on behalf of their clients.

VanDerSchie: Yeah, that makes good sense, Tom. And Paul, I'm glad you brought up risk tolerance because that was actually the next concept from the book that I wanted to discuss. And I know the advice industry is often heavily focused on a single preference as you alluded to, which is risk tolerance. And you identified some of the other preferences that should be considered. Tom, maybe from your perspective, is there anything that we didn't touch on there that you'd want to add?

Idzorek: Well, maybe on the application of risk tolerance, again, my view and the perspective that we take in the book is that practitioners are often administering a risk tolerance questionnaire, and then they take the results of that risk tolerance questionnaire, and then they directly, or I like to use the word myopically – I don't think Paul likes that word as much – but they apply it directly to somebody's financial assets or a specific account even. And to me, the danger there is that it's ignoring the broader kind of context of the person's situation. And of course, good advisors and good planners are able to consider that broader context, and that helps inform what they're doing. But a danger that we sometimes face as an industry is we now often require advisors to say, hey, you need to administer this risk tolerance questionnaire. It provides a certain result, and you're going to file that away, and you're not allowed to vary away, you're not allowed to deviate from that risk tolerance questionnaire result. And to me, that's dangerous and bad practice that is ignoring what that advisor, that planner, may know about the person's larger situation, perhaps something that was not captured in that risk tolerance questionnaire. And the approach that we're advocating for in the book is really a holistic approach based on somebody's, what we would refer to as their total economic balance sheet, a device for understanding somebody's true ability to take on risk in light of all of their assets, including their human capital, as well as what we would label a non-discretionary consumption-based liability. And I recognize it's not a legal liability, it's what we sometimes refer to as a soft liability. But in light of that interconnected system, that complete economic balance sheet, one should be thinking about what is their real ability to take on risk and in light of that holistic situation, applying risk tolerance, and that will of course end up influencing how those financial assets are ultimately invested, but it needs to be done holistically.

Kaplan: Yeah, I'd like to add something to that as well, because what we're talking about really gets to something that Paul Samuelson had said a long, long time ago. So, he points out that, lengthening the holding period in which you're investing, he said, does not change the risk. But there are a lot of people that think it does, they think there's something called time diversification. And Samuelson basically debunked the idea of time diversification. So, then you say, well, then why would people hold less risky portfolios over their lifetimes? And the answer is human capital. If human capital is very bond-like, then when a person is young, from an economic point of view, it's like they have a big allocation to bonds already. And therefore, they can go very heavily in stocks in their financial portfolio. But over time that changes, and over time that human capital becomes less and less. And therefore, it makes sense to hold more bonds in your financial portfolio.

So, over the course of your lifetime, you do generate something which looks like a glide path that says equities are going down over time. But that's not time diversification at work. This is about human capital. And this gets to the point we've been making about risk tolerance. Risk tolerance needs to be applied not to your financial wealth, but to your entire net worth, which includes human capital, less liabilities. And that's basically why people should hold less and less equities as they age. It's not because the overall risk of their portfolio, the overall risk of their net worth is going down. That you would expect to remain constant over the lifetime. So, I think the fallacy of time diversification is probably still widely held in practice. And I think Samuelson made a very important contribution here to point out that it doesn't hold.

VanDerSchie: Thanks, Paul. Okay. So, the final concept from the book that I want to touch on is asset allocation and specifically getting asset allocation right. And I know a significant portion of the book is dedicated to asset allocation. In fact, I ran a control + F on the phrase and it comes up 234 times in the book. And so, this key idea that I took away was while asset allocation is important, asset location and what type of accounts those assets reside in might be equally important. What should investors know?

Kaplan: Well, to get back to what we were just saying, what they need to realize is that their financial wealth is not their total wealth, that they have human capital, they have liabilities, and they need to put it all together so that whatever asset allocation you have in your financial assets is going to be based largely on what's going on with your human capital and liabilities. So again, if your human capital is very much like a bond – there's an example we like to use. This is an example that was given by Professor Moshe Milevsky at York University here in Toronto. Basically, if you're a tenured college professor, you have a guaranteed lifetime of income. You're at no risk of losing that income. And so that's like holding a really big bond. And therefore, you can afford to hold more equities in your portfolio when you do asset allocation in your financial wealth. The other example is, the stockbroker whose income is very much tied to the stock, to what's happening in the stock market, they're facing a lot of risk in their human capital and therefore they should be conservative in the asset allocation of their financial assets.

Idzorek: So, I might add, asset allocation oozes throughout the book. We probably could have had an alternative title for the book that would have been something like lifetime asset allocation. But in the book, we've divided it into kind of three primary parts or sections. And the first part is all about the life cycle model. And that's estimating somebody's human capital, it's feeding into that total balance sheet, et cetera. But life cycle finance is what's providing that larger strategic financial planning type plan that is essentially feeding into what Paul and I have created, which is, a new type of optimization or asset allocation optimization that we refer to again as net worth optimization. And of course, I think net worth optimization is unique in that it's including not only human capital in that optimization as a non-tradable asset held long, but it's modeling that non-discretionary consumption-based liability as a liability or a combination of assets held short, and in light of that total economic balance sheet, settling on your net worth asset allocation as well as the asset allocation for your financial assets.

And then to me a new and interesting contribution that we're making in addition to what I just described is that we're able to break out the target asset allocation for somebody's qualified and unqualified assets into two separate asset location targets. And that's the middle part of the second part of the book. We sometimes refer to that as our child model. And then in the third integrated model, those target asset allocations, so your policy portfolio for your qualified assets and your policy portfolio for your taxable assets feed into a separate type of portfolio construction optimization that is able to tell somebody what they should be buying and selling across all of their different accounts in light of their account type.

Kaplan: I would just add to that just to emphasize that this approach that we call net worth optimization simultaneously solves the asset allocation problem and the asset location problem. So, it's all done in a single optimization.

VanderSchie: So that all sounds well and good. But practically, when we talk about asset allocation, it's not uncommon for advisors to not have a complete picture of their clients' economic net worth. In some cases, that may be because the client doesn't want to turn everything over to a single advisor. So, I guess the question is, if you were an advisor facing this scenario, how would you convince your client that sharing their complete financial picture is in their best interest?

Kaplan: Well, it's sort of like going to the doctor and not telling them about what's wrong. I mean, the doctor can't treat you appropriately unless you explain what your ailments are. I think this is kind of analogous. I think the financial advisor has to say, I need all this information because it's only in your best interest that I have it so I can come up with the best solution for you.

VanDerSchie: Great. Thanks, guys. The book is called Lifetime Financial Advice: A Personalized Optimal Multilevel Approach. Before we wrap the podcast, I just want to get a 10-second takeaway from both of you. Paul, do you want to start?

Kaplan: A 10 second takeaway of the whole discussion?

VanDerSchie: If you wanted to leave our listeners with one idea, one concept, if they've fallen asleep throughout today's discussion, what's the one thing you want to leave them with?

Kaplan: Holistic lifetime financial advice using life cycle finance.

VanDerSchie: Tom, what about you?

Idzorek: I would say that life cycle finance is the most powerful way of creating great or better or optimal outcomes for investors and advisors and planners should be embracing it and reading up on it.

VanDerSchie: And guys, if our listeners want to purchase the book, how do they go about accessing it?

Idzorek: Well, the book is free from the CFA Research Foundation website. There's no login or credentials required. I bet we could put a link near the show notes if possible. But if not, Google my last name, Idzorek, Paul's last name, Kaplan, and add the word life cycle or lifetime. And near the top of your search results will be a link to that free PDF book.

VanDerSchie: Thanks, Tom. We'll leave it there. Paul, Tom, thanks again for joining us today.

Idzorek: Thanks, Nick.

Kaplan: Thank you.

VanDerSchie: And there you have it. Another episode of Simple But Not Easy. As always, we thank our guests for their time and engagement. And once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me directly at Nicholas.VanDerSchie@Morningstar.com. That wraps up this week's episode. Before we depart, if you enjoy hearing the insights on our podcast, please consider leaving us a 5-Star review on Apple Podcasts. Until next time, thanks for listening.