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The Long View
Tom Idzorek and Paul Kaplan: How to Make Lifetime Financial Advice Work for Clients
00:50:15
Two leading researchers on human capital, tailoring the right asset allocation, and more.
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- [00:01]
Jackson Financial
At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial, Inc. Jackson National Life Insurance Company, Lansing, Michigan and Jackson National Life Insurance Company of New York, Purchase, New York. Please stay tuned for important disclosure information at the conclusion of this episode.
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Jeff Batak
Hi and welcome to the Longview. I'm Jeff Batak, Chief Ratings Officer for Morningstar Research Services.
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Christine Benz
And I'm Christine Benz, Director of Personal Finance and Retirement Planning for Morningstar.
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Jeff Batak
Our guests this week are Tom Aizorek and Paul Kaplan. This is Tom's second appearance as a guest and Paul's first. Tom is Chief Investment Officer of Retirement for Morningstar Investment Management. He also serves as a member of Morningstar's 401 Committee, Public Policy Council, Global Investment Committee, US Investment Policy Committee, and the Editorial Board of Morningstar magazine. Before retiring in 2023, Paul was director of Research for Morningstar Canada and a senior member of Morningstar's global research team. He led the development of many of the quantitative methodologies behind Morningstar's fund analysis, indexes, advisory tools and other services. Tom and Paul are accomplished researchers and authors, having individually published or collaborated on numerous academic papers, accepted to prestigious peer reviewed journals, and their work has received numerous awards through the years. In today's interview, we're focusing on one of their recent collaborations, their new book, Lifetime Financial Advice, A Personalized Optimal, Multi Level Approach. Tom and Paul, welcome to the Longview.
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Tom Aizorek
Thanks for having us.
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Paul Kaplan
Yes, thank you for having us.
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Jeff Batak
Oh, it's our pleasure. Thanks again for being here. We're really excited to have this conversation. So I wanted to start, we're going to talk quite a bit about the book, but we wanted to start by sort of situating it, putting it in context. So maybe. Tom, I'll start with you. Before we dive into the details of the book, can you talk about how the research that figured into the book, how that fits into your day to day work? And also, where might a user of Morningstar products or services encounter sort of the research that underpins the book?
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Tom Aizorek
Sure, I'll, I'll attempt that. So I work within kind of the Morningstar Retirement Group and its, I would say primary offering is this type of discretionary robo like advice service that employees, you know, people with a retirement plan, you know, access through their employer sponsored retirement plan, in contrast to maybe kind of the retail robos, which I think of as being say, kind of investment centric. This type of system, in my opinion is kind of financial planning light coupled with kind of personalized ongoing portfolio management. And the book, I guess is in my mind a blueprint related to kind of maybe a similar service that I might think of as an advisor empowerment tool. And in the book as an example, we start off with a 25 year old hypothetical investor, Isabella, who's working with her planner, Paula the planner. And in the book, Paula is using a hypothetical system based on the book to deliver ongoing financial planning with investment management to her client Isabella. And we follow her throughout her life. And so again, within kind of my work at Morningstar, we're developing these types of capabilities and I'm hopeful that we'll develop further tools that would be available to not just those that have, say, a retirement plan that is using a Morningstar to power some of the services, but also to provide this to a wider group of advisors.
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Christine Benz
Sticking with you, Tom, many of our listeners are individual investors or financial advisors. To tee up this conversation for them, what's your pitch for why they should pay attention to the types of topics that you cover in the book?
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Tom Aizorek
Well, I'm bad at a pitch. I guess. I'm, I'm not convinced that, you know, the topics that we cover in this book, I think they're certainly important to ultimately to individual investors and to advisors. But I would say, you know, if we're being honest, I don't want to lose your audience. I guess the book is really designed towards kind of a sophisticated audience. I would think about, you know, the types of people that are perhaps pursuing maybe a PhD in financial planning, the types of people that work at the home office that oversees maybe a network of financial advisors and planners. So it's, you know, it's, it's geared towards a sophisticated audience. And I guess in terms of maybe why it's important, again, I think it's, again, I hate to say this, you know, because it's about our own work, but, you know, it's ground. I feel like what we're doing is groundbreaking work in terms of advancing financial planning as we know it, kind of designing and I think we'll get into this, you know, a new type of model that's related to the work of a number of Nobel Prize winners. And I guess I'm hopeful that this type of model will become mainstream in terms of its use throughout the industry, changing financial planning as we know it. So I guess anything that's going to change financial planning I hope will be of interest to Kind of a wide audience of people.
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Jeff Batak
So let's talk about lifetime financial advice. It's in the title of the book. Paul, for this one I thought we would turn to you. Maybe you can talk at a high level, explain what lifetime financial advice is and also how it differs from traditional approaches to delivering financial advice.
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Paul Kaplan
Yeah, so what we're calling lifetime of financial advice is rooted in a body of economic literature called life cycle finance. And life cycle finance has been developed by a number of Nobel Prize winning economists, and there's actually quite a number of Nobel laureates that have contributed to the field. But I'll just mention briefly four very important contributors. One was Milton Friedman, another was Franco Modigliani, Paul Samuelson and Robert Merton, and Friedman and Modigliani. When the Nobel Prize committee announced that they were the laureates, they did mention their work in life cycle finance. Samuelson and Merton developed their work a bit later, after the work that they had done that they got the prize in. So why is this important? Because economics is a way of developing really a set of tools that is both holistic and rational. And how does that differ from traditional financial planning approaches? Well, holistic. So in traditional approaches you might have one rule that says how much you should spend each year and a, and another rule that says how you should do your asset allocation in your portfolio. Those two might come from different places. And how do you know that? You know that the rules that you've chosen for those two issues actually work together. Secondly, it's rational. This is the rational approach. Of course, as we know from the work done by, you know, a number of behavioral economists, including Richard Thaler and Danny Kahneman, Nobel Prize laureates, that people don't are left to their own devices that will not behave in a rational way. And to us this means that the role of the financial planner is all the more important because that means the financial planner can take on a role of being a behavioral coach and, and help the clients make rational, holistic decisions. But to do that, they need a set of tools that are rational and holistic. And that's what our book really addresses, what such an approach looks like.
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Christine Benz
Tom, maybe you can expand on what Paul just said. Why do you see life cycle finance as critical for personal financial planning?
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Tom Aizorek
I guess I'm going to say joy or perhaps happiness or satisfaction. And so the models that Paul is talking about involve complicated interdependent trade offs that one has to make throughout their lives. And at the heart of a life cycle finance model is the idea that that investor is trying to maximize lifetime expected utility. And again, where utility is this word that is indicating, you know, joy, happiness, you know, satisfaction. And as Paul was saying to me, this is kind of the scientific method of making those complicated trade offs in pursuit of really the highest or maximum expected level of lifetime utility. And so if one were to maybe follow the traditional approach, I think they're just kind of leaving something on the table. Traditional financial planning is going to help investors and it's definitely an improvement over not planning at all. But maybe as a quick, let's say you had a person and they're kind of so, so on maybe oatmeal cookies, but they really enjoy chocolate chip cookies. They, they're happy enough eating oat milk cookies, but if they had had chocolate chip cookies, they would have been much happier. And by using this scientific type of planning, life cycle finance, planning based on life cycle finance, what you're really trying to do is make sure that you're not leaving something on the table and that you're maximizing the satisfaction or utility or joy that somebody has an association with, with all these complicated decisions that they must make throughout their lifetime.
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Jeff Batak
So I wanted to talk about human capital and liabilities. It's a concept that's very much central to the overall framework that you present in the book, Paul. For this one, I'll turn to you wondered how does the inclusion of human capital and liabilities into what you might call an economic balance sheet, how does that enhance traditional financial planning?
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Paul Kaplan
Well, what it does is it gives a complete picture of the financial situation of the investor. You know, I think if you probably asked most people to draw a balance sheet, they would put, you know, in their, you know, their mutual funds and their brokerage accounts and all that sort of thing on one side. On the other side, they put like their mortgage or, you know, or other liabilities that they have. And that's a very incomplete picture from an economic point of view because the investor is more than just those financial assets and liabilities. Human capital is a recognition that one of the most important assets that each of us has is the fact that we have a stream of income, you know, coming ahead of us from now and through the rest of our lives. And of course, when we're working, that's mainly our salary, but even after we retire, we might have some kind of social insurance, such as Social Security in the US or the Canadian pension plan here in Canada, and that we also need to count as income. And what do we do in economics? How do we look at a stream of Future income and sort of boil it down to one number is we fake the present discounted value. So that's what we do. Now there's obviously there's a question about what discount rate you should use. And we address that in the book, but that's the idea. Similarly, on the liability side, if we can look at all say our non discretionary consumption, we all need food, we all need clothing, we all need shelter, we have to pay for these things. And so in our approach, we take the present discounted value of that spending and we call that the liability. And so when we draw the economic balance sheet, on the asset side of the sheet is financial assets and human capital. And then on the right hand side we have the liabilities. And then the difference between the left and the right hand side, which is called net worth. So economic net worth is sort of the best single indicator there is of what is the financial state of an investor.
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Christine Benz
Tom, how do enabling technologies like artificial intelligence change the calculus we might have formerly used to model human capital? And does that have implications for how we build financial plans?
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Tom Aizorek
Yeah, absolutely. So I guess when discussing AI, I like to try to differentiate between kind of the latest hot flavor of AI that's in the news, generative AI, the use of these long large language models versus what I might call an expert systems type of AI. And so in the book, the models that Paul and I are advancing and developing involve simulation, optimization, probabilities, different kind of forecasting mechanisms. And I think of that as perhaps a form of an expert systems AI. And then so kind of from that perspective, I guess I feel like kind of these traditional expert systems techniques provide us, you know, with a solid foundation for just calculating human capital. You know, Paul was just talking about, you know, discounting back at an appropriate discount rate. I guess, you know, where I see perhaps AI influencing, you know, I guess the calculation, it's not really the calculation of human capital, it's more the description of it. So to the degree that we can already calculate that value, it's perhaps hard to explain what went into that calculation. Kind of what is human capital? What might alter somebody's human capital? I guess that's where I see what's going on with generative AI as being a fantastic device for taking a complicated subject and doing a better, in fact, I probably do a better job of explaining it than I'm doing right now. And so it's more probably on how do you communicate to individual investors and advisors the concept of human capital, what is changing its value, how its value changes over time. And then what are the implications of human capital for how you should be investing the rest of your assets?
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Jeff Batak
Paul, one of the concepts you discuss in the book, and it's a concept that's mentioned in the title of the book, is what you call the personalized optimal multi level approach. What is it and how does it fit into lifetime financial advice?
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Paul Kaplan
Yeah, well, the first word personalized, it refers to the fact that in a life cycle model there is, you know, this personal information that's going into it. And I categorize that into kind of three groups. So one is preferences. You know, every investor has preferences regarding, you know, how much they prefer to have consumption now versus consumption later. There's risk tolerance, you know, how much risk are you willing to take in your overall net worth? And then there are some preferences regarding bequest. How important is it to you to leave a bequest? So those are the preferences, and those preferences are really going to drive a lot of what our approach is going to get to in terms of all the decisions regarding consumption and asset allocation and how much life insurance to buy and the use of annuities. It's all going to. Everything's going to be tied back to preferences. The second one, needs. Needs are what I was mentioning earlier about liabilities. So, you know, over time we all have, you know, needs those can potentially vary over time. And, you know, so we want to take that into account as well to form our liabilities. And finally, you know, there's our circumstances, you know, how much financial wealth do we have? Where am I in the life cycle? Am I 25 and just starting out on my career? Am I older? Am I retired? I mean, all these things, these are the things that are going to impact your human capital. And so all that sort of goes in. So preferences, needs and circumstances all go into the calculations to create a rational holistic plan of how much to consume or spend and how to invest your assets.
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Christine Benz
Tom, can you explain the main components of the three level parent, child, grandchild model and why you think that framework improves on previous models?
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Tom Aizorek
Sure. So the book is organized essentially into three parts that follow that structure of a parent, child and grandchild model. So at the highest level we have our parent model, which is the model that is most closely based on life cycle finance. And in my mind, it answers those big picture questions that we've somewhat mentioned. So how much to consume, how much to save? What should be the appropriate risk level, let's say, for your financial assets in light of other things like your human capital, that Paul was just talking about do you need life insurance and how much do you need guaranteed income? If so, how much? So that's really the kind of the parent model and this kind of big picture picture of that individual economic balance sheet that Paul was talking about, those inputs are coming, those are outputs coming from that life cycle model that feed into the child model, where we call our child model net worth optimization. And net worth optimization is really an extension of another Nobel prize winner, Harry Markowitz's kind of mean variance optimization approach. But rather than just optimizing, say, one's financial assets in light of that person's balance sheet, which includes their financial capital, their human capital as assets, and their liability, we're optimizing that entire system. And so that child model produces target asset allocations for an individual for their taxable tax deferred and tax exempt accounts. And those targets then feed in to our grandchild model, the final model, which is kind of where the rubber meets the road. And in that grandchild model, which has the form of something referred to as an alpha tracking error optimization, what we've done there is we've built a model that can simultaneously look across an investor's different set of accounts and adjusts or incorporates the idea that there might be different tax types. And then in light of that information, it can say, what should you be buying and selling across all of your different accounts? And it can answer a bunch of other questions too, that we think are relatively unique. So it can decide whether or not it's in the best interest of that investor to do a rollover or maybe a reverse rollover or a partial rollover within their taxable accounts. It can be doing some like a form of holistic tax loss harvesting. If somebody has new money to deploy, this child model will say, here's the optimal place to deploy that money for those people that are withdrawing money across their accounts. It can help you decide what actually should you be selling in order to create that maybe retirement type paycheck. So, you know, quite powerful. And then I think the latter part of your question is why is this better? Well, to me, it's a cohesive framework that is all working together again based on the personal preference of that individual, their unique circumstances to provide the maximum, maybe I should say utility maximizing answer for that person.
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Jeff Batak
Let's talk about personalized advice, which is a key theme in the book. Paul, how does the model make the process of personalizing recommendations more effective and efficient overall?
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Paul Kaplan
Well, it does that because there is an underlying mathematical model that takes, you know, all these, you know, inputs into account, you know, such as risk tolerance and preferences regarding, you know, when you want consumption, preferences regarding, you know, how big a bequest you want to leave, it takes all those into account and those, those personalized preferences, you know, and as I also mentioned, you know, the, the needs, you know, so it estimates the liability and also whatever the unique circumstances of the individual, you know, regarding their human capital, all those things are going in basically going into the same sort of mathematical model. And what's coming out of the model is an internally consistent, rational, holistic set of recommendations.
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Christine Benz
Tom, what does that look like when it comes to the advice given on asset allocation or spending patterns? And perhaps you can talk about how it differs from the advice that someone would get from an off the shelf business type solution.
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Tom Aizorek
Well, the answer, I guess depends on the individual in question. You know, so if, I guess if you're Joe Average, maybe the advice coming from this type of model doesn't really look that different. Of course, I think, you know, most people are unique in terms of their circumstances and of course their preferences. And so to the degree that a person, you know, does not look like Joe Average, they're going to have a very different looking solution. So I guess for Joe Average it might look very much like that kind of standard or off the shelf type solution, but for a number of people, other people, you know, it can look significantly different and maybe that, you know, highlights what I might think. It was kind of, you know, a weakness of current practices where we, we often rely on, on heuristics. And again, you know, sometimes the heuristic is working just fine and it probably works just fine when you're a stereotypical person receiving advice. But to the degree that your situation is unique, your preferences are unique, that's when this type of personalized solution will look quite a bit different.
- [24:03]
Jackson Financial
At Jackson, we've created a digital retirement planning experience with you in mind. Visit Jackson.com to explore our easy to understand resources and user friendly tools that are designed to enable financial professionals and clients to plan a path to financial freedom. Jackson is short for Jackson Financial Inc. Jackson National Life Insurance Company, Lansing, Michigan and Jackson National Life Insurance Company of New York, Purchase, New York.
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Jeff Batak
Paul, your model allows for determining optimal consumption levels at each stage of life. How does this work in practice for individuals? Adjusting the life changes? And then related to that, how does the model help people make trade offs between immediate spending and long term financial goals?
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Paul Kaplan
Okay, well I think I can address the second question first and then we come back to the first Question. Because in the life cycle finance literature there's a term called consumption smoothing. And the idea of consumption smoothing is that when you retire, you really don't want to move to a completely different spending level than when you were working. And this is the reason why. And as I think it was generally understood, as you have income coming in, what you do is you convert some of that income into savings and you invest that savings. So your human capital tends to decline over your lifetime, but as it's declining pre retirement, you are building up more and more financial wealth as well. And then when you retire, you now have financial wealth to live off of, and so you're basically able to maintain a similar level of consumption as when you before retired. So that's what's referred to as consumption smoothing. And for the first question, of course, you know, anytime there's any change to any of the inputs, the thing to do is to update the inputs to what they are so there could be life changes. So for example, suppose you got an inheritance, now your financial wealth all of a sudden is going to jump up, so that's going to have effects on your spending and on your investing as time goes on. Or if you were to get an update on your life expectancy, you know, you put that change in life expectancy into the model and it would make the appropriate changes.
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Christine Benz
Tom, what are some aspects of financial planning where perfect shouldn't be the enemy of the good? And how does your model allow for that?
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Tom Aizorek
Probably in all areas, I guess maybe I'll start off with my kind of perception just of typical financial planning as I understand it, and maybe I don't understand it correctly, but it seems as if there's usually this relatively large exercise up front where somebody is going through the plan, they're gathering information, and eventually the plan is created. And then again, as I understand it, unless there's some sort of major change in that person's life circumstances, what would happen is that they'd come back in a year or so and revisit that plan, I guess in terms of the new type of robo esque financial planning light auto portfolio management system that again I think the book is presenting, is really designed to be perhaps more akin to an auto rebalancer, but for your financial plan. And so if everything in the book, as we've put it out, could come to fruition, you know, as things changed, the plan would simply just update automatically and therefore, you know, hopefully perfection wouldn't be the enemy of good here, you know. So Paul just gave some great examples I guess I'm thinking, you know, if perhaps more typically, you know, if the markets went way up or they went way down or maybe, you know, one month somebody, you know, had to spend a lot more than they had anticipated. Again, if done correctly, this would feed into an auto updating financial plan that could be essentially carried out on behalf of that person without having to come back a year later and say, where have we gone awry? Where haven't we? And it would be a bunch of small rapid fire, I would say, you know, kind of course corrections as opposed to that kind of annual course correction.
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Jeff Batak
Shift and talk taxes Paul, the paper discusses the role of tax efficiency and asset location. Could you explain how single period and multi period optimization, these are concepts that you cover in the book, how those work together for tax efficient investing?
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Paul Kaplan
Yes. So as we've mentioned, the book presents a three level model. So there's the first model, the parent model, and that's, that's the life cycle model. That's the model that really comes out of the life cycle literature and that is a multi period optimization. Because what you're optimizing is the amount of what economists call utility or I think as Thomas referred to as happiness. You know, what makes you the happiest over the course of your life? What level of consumption do you want? Let's say each year, let's say now, each year you want to do a kind of a review and implementation of your asset allocation. So what you want to do is to do an asset allocation both within your taxable assets and your tax deferred assets or your, you know, your, any things that are qualified, where you're not going to be paying taxes right away on. And the approach we have there is basically an extension of the model created by Harry Markowitz in which there are two kinds of assets. There's taxable and let's call them the ones that have a tax preference. So year in and year out you have to pay the ones on the, what you earn. On the taxable side, you have to pay taxes on that. And that's what we've done is we've incorporated the taxes to come up with an after tax return on those assets. And then you have the other assets which you know, which you're not paying an immediate tax on. And those have a different, you know, those are going to have a different level of return even if you're investing in the same asset class. So what we do in this child model is from the parent model, we get all the information about the economic balance sheet. And we bake that into this approach that comes up with, you know, what your asset allocation should be in taxable versus tax deferred, you know, or tax exempt assets. So you, what you might expect to happen in this is in terms of asset location is that you would have your most tax inefficient assets. You would expect to find those in the, let's say, the tax advantage side of things. So that would typically include bonds. And then on the things that are more tax efficient, like stocks, you would expect to find those on the taxable side. But it doesn't always necessarily exactly work out that way. It just all depends upon how all these inputs come together.
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Christine Benz
Tom, what practical advice would you offer to individual investors or financial advisors seeking to maximize tax efficiency? Apart from reading your book, that is?
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Tom Aizorek
Well, you guys work with me. Practical advice, kind of on the fly. That's not my strength. Can I phone a friend and can I ask them to call you? You know, I guess I would channel my inner Christine Benz and you know, and I think Paul was kind of answering some of those questions a little bit. But so in your taxable accounts, what would you say? You know, it'd be low cost passive investments, you know, that are hopefully going to be relatively tax efficient should be owned in your taxable accounts. And then in general, as Paul probably just said, you know, to the degree that something's tax inefficient, probably, you know, like say your bond funds and your fixed income funds, by and large should be held in qualified accounts.
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Jeff Batak
We'll stick with you, Tom, for a minute and talk about non financial preferences. Some of our listeners perhaps don't define success in strictly financial terms. How does the model incorporate non financial preferences, which can be stuff like what in the industry is called esg, for instance.
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Tom Aizorek
Sure, a great question and of course I think it's a topic that is near and dear to our hearts, at least, I guess stepping back and submit, you know, Paul and I, along with Roger Ibbotson and James Young, you know, also of Morningstar, I feel like we've done a lot of work in kind of this, this world of kind of non financial preferences and how the in house kind of the aggregate preferences of people ultimately influence asset prices and personalized portfolio construction. I think, as you may know, we created a homegrown asset pricing model that we'd argue could have improved upon the most ubiquitous asset pricing model, the capital asset pricing model, where our model is called the popularity asset pricing model. And so, you know, a bit earlier I was, I was Discussing, you know, the child model, which is that alpha tracking error optimization model where we're deciding what to kind of, you know, buy and sell. And so it's in somewhat, in part two of the book, mostly in part three of the book, you know, we discuss how one might first of all measure the degree to which somebody has, you know, non pecuniary or non financial preferences. Those could be related to ESG or any other. They could be for religious reasons, other value reasons, or you know, whatever is important to the end investor. And what we've done is using, you know, kind of the overall framework that we've been talking about where, where trade offs matter after one is solicited those preferences, those, those non financial preferences. How do you actually build a personalized portfolio that reflects the preferences of an individual?
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Christine Benz
To stay with you, Tom, do you see increased demand for ESG customization among individual investors? And what advice would you give advisors on this trend?
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Paul Kaplan
Sure.
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Tom Aizorek
Customization in general, right. I think is something that we've all come to expect in maybe all aspects of our lives. And again, whether it's ESG or otherwise, I think we just all want more and more tailored solutions that meet our needs. And so as a trend, I just think that personalization, it's only growing where only the need that advisors will need to fulfill is how do they meet their clients needs in a more and more personalized way. So I guess I see the trend as just the need for more customization. In my mind, kind of the advisor world today is filled with kind of the concept of the model portfolio. And the advisor has their model portfolios and they're trying to use those to manage the money of their book of business. And I guess in my mind that was due to technological limitations of the past. It used to be avant garde to have a model portfolio. I think that we are now at a point in time where again, using some of the methods described in the book, there are methods for advisors to provide truly personalized portfolios for their entire book of business in a way that is just as easy and scalable from an advisor's perspective as using a model portfolio. So again, I guess to me the big trend of personalization is here. ESG has become a bit of a politicalized issue here in the United States. But again, big picture, I think the concepts and ideas behind ESG are very important to the degree that they manifest for a given investor. Again, the important thing is the tools are here for an advisor to reflect whatever values a person has in a given portfolio.
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Jeff Batak
Let's shift and talk a little bit about risk management and insurance products. Paul, can you explain the role of insurance products like life insurance and annuities within the lifecycle model?
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Paul Kaplan
Yes, and actually, you know, the, the usefulness of those products arises out of the fact that none of us knows when we're going to take our last breath. And so life insurance deals with the side with the mortality problem, which is that, you know, if there are, let's say, if we have people who are depending on our income and, you know, and if, and if our lives end, you know, early, the problem is that those people that were depending on us won't have anything anymore. So what you do is we buy life insurance at that point. So if something were to happen to us, there's something left for those that are depending on us. And the annuities deals with the other end of that problem, which is longevity risk. Since we don't know when we're going to take our last breath and there might be a lot of longevity as we're seeing, then the problem we could face is that what happens to our financial resources, we don't want to live beyond our means. So what we do is we could buy annuities to address that problem and create a guaranteed level of income that will last as long as we do.
- [38:42]
Christine Benz
So to follow up, Paul, how do your recommendations around life insurance and annuities change as investors move through different life stages? It sounds like once dependents have left the nest that you would move away from life insurance to more of something that will protect you against living a really long life. Is that how you think about it?
- [39:02]
Paul Kaplan
Yes, but also there's a little bit more to it, which is, you know, what type of life insurance should you buy? Right. This term life, this home life. And there's other, other variations. So the thing is this is that while you are working and you are converting your income into financial wealth, that means the need for a given level of bequest, your need for life insurance should be reduced over time, and you may be able to, in fact, have enough money put away that you don't need life insurance anymore at all. And if you're following that strategy, then what you need is term life insurance, where every year you renew your life insurance policy, but you only renew it to the extent to which you need it. And so the amount of term life insurance you buy each year is going to gradually be reduced now once you get to that retirement phase. And now, yes, you're going to switch from worrying about mortality risk to worrying about longevity Risk, then you want to use annuities to create that income stream. Now, on the annuity side, there's a lot of confusion about what exactly is an annuity, because there's a type of product called a variable annuity, which is not really an annuity. It's an investment product that can be converted to an annuity at some point in the future. However, you can buy really plain vanilla annuities are available. You always, of course, as with any insurance product, you have to look at how much it's going to cost you. But if you can get just a plain simple payout annuity at a reasonable price, that would be the direction to go.
- [40:56]
Jeff Batak
Tom, one risk you addresses, longevity risk. How does the model help individuals and advisors plan for the uncertainty of life expectancy? We talked about that on a related topic, which is sort of mortality insurance, but specifically on longevity. Curious your thoughts on that and maybe also some actionable insights for retirees to ensure they don't outlive their assets.
- [41:19]
Tom Aizorek
Sure. So again, discussed the concept of kind of, you know, maximizing lifetime utility, which is looking at kind of all of the periods in the future where the person, you know, could be alive. And kind of incorporated into that model is a model of, you know, we don't know how long the person will live, but there is a probability that at any given point in time, you know, that, that they might pass away and, or that they would be alive. And then I'd say this is actually, you know, another strength of the model is that schedule of probabilities of that person being alive at any given point in the future can be personalized for that individual based on their unique knowledge of kind of their health situation and perhaps, you know, family members longevity. In terms of kind of actionable insights, you know, what can, what can people do, you know. Well, I would just say, you know, I gotta go run some numbers. You could use one of the online calculators to see how they're doing. Obviously you could go meet with a planner. And then as Paul was just talking about, one option is to buy a real annuity. And then should one choose not to use annuities, then you of course have to be willing to alter your consumption depending upon how your portfolio is doing.
- [42:47]
Christine Benz
So what changes do you think are needed in the financial advisory industry to implement such a comprehensive approach as we've been discussing here today? Paul, perhaps we can start with you on that and then Tom, maybe you can chime in.
- [43:01]
Paul Kaplan
Yeah, well, I think the first thing is that financial planners would have the option of using some kind of software system which is based upon the models that we describe in the book, and then they could put it into action, but perhaps also with that maybe some change in the education financial planners, because I don't think life cycles and answers is actually taught to financial planners, and yet it is so foundational to what they might do. You know, I'm thinking just by analogy, I can remember, you know, like taking a course in chemistry, but before you get into the chemistry part, you first have to learn the model of the atom, because that's fundamental. You have to understand the atom first before you can understand molecules and chemical properties and all that kind of thing. So, so I guess another thing would be, in addition to software would be, you know, somehow working this into the education of financial planners and so picking.
- [44:07]
Tom Aizorek
Up kind of a lot more on the industry side. To me, you know, so many of the kind of integrated, larger, you know, financial service companies, you know, they often have, you know, a retirement business and a wealth business. And I guess to me, a core concept within life cycle finance is trying to be holistic and to holistically manage all of the assets of a person, given their situation. And I guess I just, I feel like there are, there are barriers where, you know, one bucket of money, one pocket of money is getting perhaps managed, you know, one way within their 401k, and then separately, other money is being managed, you know, by a wealth advisor. And of course there's, you know, great advisors, great planners that are over able to kind of overcome that, that hurdle. But I do see that hurdle as, as a real one in terms of really acting holistically in the best interest of investors.
- [45:08]
Jeff Batak
So for our last question, I wanted to shift gears a bit and talk about a topic that's unrelated to the book that we very much enjoyed talking to you about the book and exploring it. And that's John Recenthaler. John Recenthaler, our colleague, recently announced that he's retiring from Morningstar after a very distinguished and long career during which he's worked with, collaborated with both of you. So I wondered if maybe you wanted to offer any sort of reflections on the experience that you had working with John through the years. Paul, maybe we'll start with you and then Tom, if you'd like to contribute to be interested in your perspectives too.
- [45:45]
Paul Kaplan
Yeah. So back in 1999, John hired me and I really enjoyed working with him. Initially we were working on our online advice system, and then I also had the opportunity to work for Don Phillips for a couple years, and then John again. And in my mind, Don and John are like, I mean, they kind of really, they contributed so much to morningstar, you know, really being the kind of face of Morningstar to financial planners and investors. And I always enjoyed all my time, you know, for the 25 years, starting 25 years ago, working with John.
- [46:31]
Tom Aizorek
And so I'm happy to chime in as well. So, you know, Jeff, you sent out an email internally last week and kind of announcing John's planned retirement. I'll just say I was very surprised. And I guess one of the reasons I was so surprised is that ironically, I guess Paul and I had been on a call, I guess, just days earlier with John, pestering him perhaps around again, ironically around some of the work of Paul Samuelson and how to interpret it. And again, I was worried that we were really kind of pestering John, but we talked about retirement and what that might look like for John. And of course, Paul has been retired for a year plus now and what life is like. But to echo what Paul has said in my mind, Christine and Jeff, I'd almost be interested in your opinions as well. But for all of us at morningstar, it's hard to think of outside of first, I guess Don Phillips and then John, who has had a more profound influence on kind of the firm, I guess Joe and Kunal, but from a research lens, kind of thinking about how do we act in the best interest of investors. Again, I think of Don and John as really being kind of the people that have created the fabric of Morningstar. And so I'm sad to see John retire, but luckily I know how to reach him and I plan to reach out often.
- [48:12]
Jeff Batak
Well, I think I speak for Christine in saying we couldn't say it any better. We very much echo those sentiments and maybe we'll close. On that note, just wanted to thank both of you, Tom and Paul, it's been very enlightening discussion. Thanks so much for your attention, time and insights. We very much enjoyed chatting with you.
- [48:28]
Tom Aizorek
Thanks.
- [48:29]
Paul Kaplan
Thank you.
- [48:30]
Christine Benz
Thanks to you both. Thank you for joining us on the Long View. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts. You can follow me on social media at Christine or at Christine Benz, on.
- [48:54]
Jeff Batak
LinkedIn and @suouth1, which is syouth and the number one.
- [49:00]
Christine Benz
George Cassidy is our engineer for the podcast and Carrie Gretchik produces the show Notes each week. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us@thelongvieworningstar.com until until next time. Thanks for joining us.
- [49:20]
Jackson Financial
This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. And its affiliates, which together we refer to as Morningstar. Morningstar is not affiliated with guests or their business affiliates. Unless otherwise stated. Morningstar does not guarantee the accuracy or the completeness of the data presented herein. This recording is for informational purposes only and the information, data analysis or opinion it includes or their use should not be considered investment or tax advice and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any trading decision, damages or other losses resulting from or related to the information, data analyses or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision. Please consult a tax andor financial professional for advice specific to your individual circumstances.
- [50:58]
Tom Aizorek
SA.