Aging and financial decisions

Posted by on October 17, 2011 @ 9:42 am in Personal finance

Global aging is a familiar idea. Not only are populations in the advanced economies aging rapidly, but so are those in emerging countries. For investors, the aging trend poses a number of broad, sometimes philosophical questions—the sustainability of public benefit promises to the aged, the impact of aging on markets, and expected investment returns.

But one issue is much more personal: the impact of aging on our own abilities (and the ability of our loved ones) to make informed financial decisions.

I recently attended a talk on this topic in Boston. It was given by David Laibson, professor of economics at Harvard and a leading behavioral economist. Dr. Laibson has taken up the cause of cognition and aging. In his talk, he first distinguished between “fluid” and “crystallized” intelligence. Fluid intelligence is the intellectual skill needed to complete abstract word, numeric, and visual problems, and is key to solving new problems. Unfortunately, for all of us who are no longer young adults, fluid intelligence peaks around age 20 and declines steadily thereafter. Crystallized intelligence is based on experience and accumulated knowledge—what you might call wisdom—and helps with solving familiar problems. Thankfully, it continues to rise until age 60.

Dr. Laibson also presented some evidence that financial decision making is hump-shaped (inverse U-shaped) over the life cycle. When you are young, you may be fast intellectually but lack experience, so your financial skills are low. As you age, your experience grows a bit faster while your cleverness declines, so you reach a peak during midlife. As you continue to age, both factors trend downward. As a result, Dr. Laibson argues, financial skill appears to peak at age 53.* This is of course an average tendency around which there is likely to be much individual variation. (And of course it is just the first applied research giving this type of specific estimate, so no doubt we’ll have different estimates from future research.)

As you age, the risks of cognitive decline grow. The numbers are breathtaking (see chart). Over age 60, dementia rates double every five years, so that nearly a third of those age 85–89 suffer from the problem. What’s more, cognitive impairment short of dementia afflicts a similarly sized group, so about half of those of us who live into our 80s will struggle with making financial and investment decisions.

Prevalence of dementia in North America:

Age Rate
60–64 0.8%
65–69 1.7%
70–74 3.3%
75–79 6.5%
80–84 12.8%
85–89 30.1%

 Source: Ferri et al. 2006.

What to do? On the policy, legal, and regulatory front, there are many ideas to encourage greater protection for older decision makers. But this is a family issue that requires attention today. As just one example, a family I know has gradually transitioned complex portfolio decisions from aging parents to adult children in their 50s. Meanwhile, the parents retain direct control over day-to-day spending decisions, while major financial transactions are vetted through the family. In effect, the family has created a protective barrier around their aging parents, attempting to insulate them from dishonest solicitations, and to prevent major financial errors.

This within-family approach requires honest children (or honest younger relatives or friends), and honesty can be in part enforced by transparent communication among all involved. But as a reminder of the challenges even within families, Dr. Laibson mentioned the case of Brooke Astor—the New York heiress who, despite access to substantial resources, was taken advantage of by a family member.

Advisers, both investment and legal, can help with a plan. But no particular strategy is foolproof. For example, I can pick an adviser I trust in my 50s or 60s to help manage my assets. But will that same person be around, still advising, when I’m in my mid-80s? Unlikely.

Another challenge is coming to grips with our own declining skills. Just as building wealth requires foresight and planning when we are young, so too does successfully managing assets into old age mean having the foresight to recognize that our own skills might falter. It means handing over the reins—sometimes earlier than you might have hoped.

Too many older drivers don’t give up driving until after an accident or two. The same is true when it is time to give up steering the portfolio. It’s best to hand over responsibilities in a planned fashion and not wait until a major financial accident.

* This is a finding I’ve written about before.

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