Sunday, December 7, 2008

Financial Advice

In earlier posts, I have discussed financial advice and the fact that most people tend to consult family and friends when making financial decisions. In this post I would like to discuss consulting financial advisors. There is little research on this topic, but it seems to me it is an important area of interest. In a new financial world, where financial instruments are increasingly complicated, professional financial expertise can be very valuable. We may associate this sort of financial advice with setting up trusts, legal counseling, and complex investment strategies that preoccupy only the rich. In fact, financial decisions of the average family or individual have become sufficiently complex that such advice may be not only beneficial but also necessary. More so when, as I have argued repeatedly, there is very low financial literacy. Overall, it is not easy to choose the best mortgage (or even a good mortgage) among so many options. Similarly, it is not easy to know how much to contribute to a pension plan and how to allocate pension assets, not to mention how to best save for children’s education or simply how to deal with debt.

While many would admit that these decisions are difficult, few consider getting professional financial advice. Clearly, cost can be an issue, but it is not obvious that the cost, in most cases, is greater than the benefits. Consider, for example, retirement planning: setting up a plan for how much to save and how to invest retirement wealth may be very beneficial. According to the Retirement Confidence Survey and my own work using many waves of the Health and Retirement Study, many workers do not know how much they need to save for retirement. Even those who claim to have done some calculations are often not able to give the amount they will need at retirement or give figures that seem very rough estimates. This may reflect the fact that workers use rather crude tools to make retirement saving decisions. For example, a quarter of those who report being planners do not use any planning tools at all! However, planning does pay off. Those who report doing calculations of how much they need to save for retirement end up close to retirement with three times the amount of wealth of those who do not plan. And do not think that planning and financial counseling is simply for those who can afford it (i.e., those who have wealth). Counseling can be even more beneficial to those for whom every dollar counts. How families manage their balance sheets is very important, and making good financial decisions may have huge implications on our well-being, as the current crisis seems also to suggest.

Yet, people give little thought to these decisions and few consult financial advisors. Clearly, it may be challenging to find good financial experts who are motivated by incentives that do not work against consumers’ best interests, such as those whose compensation derives from high fees assets. But in my view, one reason we do not generally consult experts is that it is hard to know whether and when we are in financial trouble or can prevent financial trouble. For example, without going through the planning process, there is little to signal to people that they are not saving enough for retirement, particularly when they are many years away from it. We may only realize we have not saved enough when it is too late. It might be interesting to consider an analogy to guidelines regarding health maintenance issues. First, we do not normally self-medicate (or do surgery on ourselves) but we go seek (or should seek) medical advice when we have a problem. Second, even without being in pain, we tend to do check-ups to make sure we are in good shape and we will not have problems in the future. Third, we ask for a second opinion when in doubt. Wouldn’t it be a good idea to do the same for our finances?


flybymike said...

Yes, we should. At my Association, one priority in selecting a new administrator for our 401(K) plan was the educational and planning tools the administrator made available. The company we selected has very good tools, including an analysis of how much the employee will have at retirement based on their current salary and savings vs. how much the employee needs. We also have the administrator meet regularly with staff, via staff training sessions, and one-on-one meetings for more specific questions/issues. So retirement plan savings education is an easier issue to address.

From my perspective, the more challenging issue is savings outside company-sponsored retirement plans. In my experience, the more money one is willing to invest with a financial adviser, the more attention one receives from that adviser. That's unfortunate and is an area that can/should be improved upon by the financial adviser industry.

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