Tag: income

Does Failed Retirement Income Planning Really Result In Bankrupt Financial Ruin?

Does Failed Retirement Income Planning Really Result In Bankrupt Financial Ruin?


While it is a topic most retirees hope to avoid ever dealing with, the reality is that not all retirement income plans will be successful. Whether due to a retiree’s refusal to plan, reluctance to take the advice of a professional, or simply due to unfortunate circumstances which were outside of a retiree’s control – failures in funding retirement can and do occur. In fact, financial planners routinely do Monte Carlo projections for retirees to determine their prospective probability of failure, especially given growing awareness of sequence of return risk.

Yet given the reports of low levels of both objective measures of retirement preparedness (such as savings) and subjective measures of retirement preparedness (such as retirement confidence), many financial advisors may be surprised to learn that bankruptcy rates among those over age 65 appears to be less than 3 per 1,000, and actually declinesamong older retirees. So, what’s going on? If retirees are living longer than ever – which should be making retirement more difficult than ever to afford and sustain, especially given the long-term impact of sequence of return risk – then where are all of the bankrupt retirees?

In this guest post, an examination bankruptcy among retirees, finding that the reality is that bankruptcy may not be a great indicator of retirement income planning failure. A retiree who blows through their nest egg doesn’t necessarily end up bankrupt, they simply need to adjust their spending downwards to their new reality. Social Security plus public assistance represent the true consumption “floor” for most. Further, bankruptcy may not even be a great indicator of actual financial strain, as given the rules surrounding bankruptcy, the ways that retirees deplete their retirement assets does not necessarily trigger an actual bankruptcy filing, especially in light of the ways in which bankruptcy laws favor those in retirement.

Nonetheless, the point remains: with longer life expectancies and struggles with retirement preparedness, especially combined with the difficult markets of the past 15 years, the retiree bankruptcy rate is shockingly low. Which suggests that the overwhelming majority of retirees facing retirement shortfalls really are able to downsize their lifestyle to avoid financial ruin when the time comes. Of course, few retirees want to risk even a major lifestyle setback in retirement if they can avoid it. Still, though, if most retirees really are capable of making spending adjustments when necessary… shouldn’t those potential adjustments be better reflected in financial plans in the first place?


Chapter 7 bankruptcy is the type of bankruptcy most people generally think of when they hear the term “bankruptcy”. Also known as “liquidation” bankruptcy, the Chapter 7 bankruptcy process entails having a debtor’s assets transferred to a bankruptcy estate, where the assets are liquidated to pay to repay creditors, and any remaining (eligible) debts are discharged.

Notably, Chapter 7 doesn’t apply to all forms of debt, and there are some requirements that need to be fulfilled in order to qualify for Chapter 7 in the first place. First, an individual’s income must actually be low enough (at least relative to their debts) that they qualify for Chapter 7 bankruptcy. While the income qualification criteria can get fairly complex, in essence, the income tests assess: (1) whether the individual’s income less than the median in their state; or, (2) if the individual’s income is above the median, whether their disposable income low enough to indicate true financial strain. If either test is met, the individual “passes” and is eligible to file for bankruptcy.

Means testing was introduced in 2005 as a way to combat some abuse of the bankruptcy system – effectively reducing the ability of someone with material income and means to claim bankruptcy (notwithstanding the various bankruptcy exemptions and protections). However, an important caveat to this test—particularly from the perspective of individual’s considering bankruptcy in retirement—is that Social Security income is exempted from one’s income for means testing purposes (effectively making it easier for many retirees to file for bankruptcy).

Beyond these requirements, the debt must actually be dischargeable under Chapter 7. Many common forms of debt, such as credit cards, medical bills, and collections accounts can be discharged. However, other forms of debt or financial obligations, such as student loans, child support, and alimony, generally cannot… which means that someone struggling with those debts would still likely never end up in bankruptcy.

Under Chapter 7 bankruptcy, certain assets are also exempt from liquidation, allowing the debtor to keep those assets while going through bankruptcy. While there is a lot of variation from one state to another, exempt assets include personal property that would be of little value through liquidation (e.g., clothes, household goods, and food) as well as other assets of more substantial value (e.g., wedding rings, vehicles, retirement accounts, and equity in personal residences).


Unlike Chapter 7 bankruptcy, Chapter 13 bankruptcy is a “reorganization” bankruptcy. Chapter 13 does not involve the same liquidation process. Instead, Chapter 13 bankruptcy aims to help debtors come up with plans to get on track and repay (at least some of) their debts.

Chapter 13 bankruptcy is only available to those receiving regular ongoing income. 11 US Code Section 109(e) restricts eligibility for Chapter 13 bankruptcy to only those with less than $394,725 of unsecured debt or less than $1,184,200 of secured debt (thresholds will be updated again in 2019). Debtors are required to participate in credit counseling and development a repayment plan for their debt.

Filing for Chapter 13 generally puts a “freeze” on any current collection efforts, providing some temporary relief while the debtor goes through Chapter 13 proceedings. A trustee is appointed to administer the bankruptcy, and then debtor then makes payments to the trustee, who will then distribute those funds to debtors, according to the repayment plan developed and approved by the court. The debtor is also prohibited from acquiring new forms of debt without permission of the trustee. If a debtor fails to make payments under Chapter 13 bankruptcy, the court may convert the bankruptcy to a Chapter 7 bankruptcy, requiring the liquidation of assets to repay creditors.

The advantage of a Chapter 13 bankruptcy is that an individual may be able to keep their possessions and get back on track, without being compelled to liquidate all of their non-exempt property. Chapter 13 bankruptcy cases generally last from 3-5 years, and, similar to Chapter 7 bankruptcy, some forms of debt can be discharged (i.e., eliminated without actually being fully repaid) upon the completion of the Chapter 13 bankruptcy repayment plan (though obligations such as mortgage debt, child support, alimony, and certain taxes will need to be repaid in full).

Bankruptcy Filing Rates In Retirement

Because bankruptcy filings are a public process (in order to affirm that all debts have been satisfied, bankruptcy involves a public notice process to alert creditors who may have outstanding claims) it is possible to determine the frequency of bankruptcy filings.

Bankruptcy Filings Per 1000 US Population

The chart above reports bankruptcy filing rates by age group (non-business Chapter 7 plus Chapter 13). Thorne, Warren, and Sullivan (2008) found that in 2007, the bankruptcy rate per thousand U.S. population peaked at the age group of 35-44 with 6.5 per thousand. For individuals between ages 55-64, this rate declined to 4.9; between 75-84 the rate was 1.6 per thousand; and beyond age 85 the rate was so low it was negligible.

This declining rate of bankruptcy in among retirement-aged individuals is notable, because the greatest risk for retirees is outliving their money. Yet with bankruptcy rates decreasing among older adults, the data suggests that bankruptcy in retirement may not be (at least primarily) the result of depleting a portfolio due to longevity or inadequate savings going into retirement!

What Causes Bankruptcy In Retirement?

The fact that bankruptcy filing rates are higher in the early years of retirement and decline in the later years (even as retirement assets would also ostensibly be depleting) raises the question about what actually doestrigger bankruptcy in retirement, if not asset depletion.

A 2010 study from Deborah Thorne at the University of Ohio on theinterconnected reasons that elder Americans file for bankruptcy found that credit card debt and illness/injury (which can trigger substantial medical expenses, which may subsequently turn into unpayable medical debts) were the two leading causes of bankruptcy among the elderly (based on self-reports from those who had filed for bankruptcy). As Dirk Cotton has pointed out, sequence of return risk does not appear to be a significant contributor to bankruptcy among the elderly, as only 6.7% of filers reported “retirement” as the source of their bankruptcy, and again bankruptcy rates are highest in the early years of retirement—when failures due to sequence of return risk (based on reasonable withdrawal rates) are mostly non-existent.

As Cotton has argued (and Thorne’s study supports), it appears that thepredominant cause of bankruptcy in retirement appears to be an unanticipated shock to one’s income or expenses that results in them becoming overextended and not being able to meet their financial obligations. It’s important to note that these shocks are different than someone just living beyond their means, as running a portfolio to $0 doesn’t necessarily trigger any conditions that would even make one eligible for bankruptcy. Depletion might require a material downward adjustment in one’s level of spending, but with no debts outstanding that cannot be paid, there is no actual trigger for bankruptcy.

As indicated in the chart above, bankruptcy actually seems to decline with age. Which, consistent with the Thorne’s (2010) findings, would suggest that financial shocks are a more significant cause of bankruptcy in retirement than depleting portfolios. However, what may remain unclear is why financial shocks would decline with age as well. To address this question, it is helpful to look at who is susceptible to financial shocks in the first place.

Who Is Susceptible To Bankruptcy In Retirement?

A few factors would seem to primarily drive susceptibility to bankruptcy in retirement. The first is financial fragility, which is the degree to which a small shock in a household’s income or expenses could have a big impact on their overall situation. A household’s debt-to-income ratio (monthly debt payments divided by monthly income) is an important indicator of fragility. Another would be the Fed’s financial obligations ratio, which looks at how much income goes towards fixed payments. All else equal, the higher percentage of a household’s current income that is going towards fixed payments, the more susceptible they are to either an income or an expense shock.

Naturally, one important driver of the debt-to-income ratio is the presence of debt in the first place. Even if a household does have to rely on credit to fund an unexpected medical expense, the less debt they currently have, the better positioned they will be to meet this unexpected obligation.

By looking at data from the 2012 Health and Retirement Study (HRS), we can notice a few general trends related to the use of debt amongst individuals at different ages. First, not surprisingly, the percentage of individuals self-reporting themselves as retired increases with age. At age 55, this number is roughly 10%, but it reaches 80% by age 75. But then we can also see that the percentage of people reporting mortgage or other forms of debt also declines with age. At age 55, 37% report having a mortgage and 44% report having other debt. Among those age 70, these numbers decline to 20% and 27%, respectively.


Trends In Self-Reported Retirement Status And Use Of Mortgages And Other Debt By Age

The presence of debt is important because it is a potential source of financial fragility—as debt itself (and an inability to repay it) is the actual trigger of bankruptcy. Debt isn’t always a sign of fragility, as sometimes debt is simply used strategically and there is no material risk of insolvency, but fragility due to debt can be particularly concerning when debt is tied to a retiree’s basic living expenses.

For instance, if a retiree enters retirement with a $1,500 per month mortgage, then they have $18,000 per year earmarked towards a fixed expense (assuming they don’t move or refinance their mortgage, or use a reverse mortgage in retirement to avoid the ongoing payment obligations). It’s these fixed expenses which pose the greatest risk if a retiree experiences an income shock. And then, as Dirk Cotton has noted, things can quickly pile on top of each other and spiral out of control—perhaps as a retiree tries to make things work by taking on credit card debt, pulling equity out of other assets, or turning to high cost lending sources. In other words, while bankruptcy isn’t usually triggered by simply depleting a portfolio, having or taking on a substantial debt – either in response to a financial shock or carrying it into retirement from one’s working years – does increase the likelihood that a retiree will be unable to meet their obligations, and thus need to file for bankruptcy.

However, not all factors which drive susceptibility to bankruptcy actually have anything to do with a household’s overall financial health. For instance, the proportion of exempt to non-exempt assets would be another important factor which influences how likely a retiree may be to file for bankruptcy.

Consider the following example:

Example 1. John is 65 and recently retired. He receives modest Social Security income, has no debt, and his only substantial assets are his $250,000 401(k) and his $150,000 home in a state that offers a 100% homestead exemption. Beyond this, John only owns some personal items and a very modest used car.

Tracy is 65 and recently retired. She receives modest Social Security income, has no debt, and her substantial assets are a $250,000 taxable portfolio (proceeds from the sale of her business) and her $150,000 home in a state that offers only a small homestead exemption. Beyond this, Tracy only owns some personal items and a very modest used car.

While John and Tracy have relatively similar financial situations from a retirement income perspective, their susceptibility to bankruptcy given a financial shock are very different. Because nearly all of John’s assets are exempt assets from a bankruptcy perspective, a bankruptcy may not harm him much at all. Ignoring potential moral considerations regarding the strategic use of bankruptcy, John could choose to have large and unexpected medical expenses discharged through bankruptcy with little to no adverse impact to himself. Further, John may be able to do so regardless of his actual ability to afford the medical expenses, as his ongoing Social Security income, 401(k), and personal residence are all exempt from bankruptcy.

Meanwhile, the same is not true for Tracy. Because nearly all of her assets are non-exempt assets, bankruptcy is of little strategic use to Tracy. If her assets (less a modest homestead exemption) are sufficient to cover the medical expenses, she is better off just paying them. Thus, John’s higher proportion of exempt assets makes him more susceptible to bankruptcy as a retiree, even though his underlying financial situation is fairly similar to Tracy’s.

And this example illustrates why retiree bankruptcy may not always be a great indicator of actual financial strain. Particularly given the ways in which bankruptcy laws favor retirees (e.g., exempting the types of assets retirees most commonly own and excluding Social Security income from means testing), bankruptcy could sometimes even make sense as a wealth-maximizing strategy in retirement.

Portfolio Depletion As A Bankruptcy Trigger Or “Mere” Spending Adjustment?

In the context that most financial advisors discuss bankruptcy with retirees, the primary concern is that spending all of one’s assets will result in “financial ruin” and cause the retiree to go bankrupt. However, as the data shows, this is rarely actually the case.

Instead, spending down most or all of one’s assets merely necessitates a downward adjustment in retirement spending. Some retirees may try and fight this adjustment, turning to credit cards or other sources of debt to unsustainably prop up their standard of living, but this is different than simply running out of assets — it’s the active accumulation of more obligations beyond spending down one’s portfolio!

Of course, to the extent that a portfolio drawdown exhausts reserves which could be otherwise used to absorb a financial shock, depleting a portfolio clearly increases the potential risk of bankruptcy.

Consider another example:

Example 2. Tracy is 65 and recently retired. She receives modest Social Security income, has no debt, and her only substantial assets are her $250,000 taxable portfolio and her $150,000 home in a state that offers only a small homestead exemption. Beyond this, Tracy only owns some personal items and a very modest used car. However, Tracy’s lifestyle does not align with her savings. Tracy recently met with a financial planner who determined that her current spending would require about $50,000 per year in income from her portfolio in order to supplement her Social Security income. Tracy’s financial planner estimates that she will spend down her portfolio after 6 years by taking $50,000 per year in income from her portfolio.

Is Tracy going to face bankruptcy once she spends down her portfolio? Not necessarily.

While she is going to face a tough wake-up call regarding her spending going forward, her lack of debt means she’s not actually in trouble with any creditors. However, what spending down her portfolio does do is eliminate some assets that can be used to alleviate a financial shock, such as an unexpected medical expense, which, if she attempts to pay for with debt, can end up triggering a bankruptcy later.

Notably, if her assets were in a 401(k) or had strong homestead protections, then bankruptcy might be a viable path for Tracy to handle an expense shock such as medical bills. As a result, she may actually be moresusceptible to bankruptcy with exempt assets — though bankruptcy would actually be a wealth-enhancing strategy for her, rather than an indicator of financial strain! Of course, if Tracy is on Medicare, then this risk is limited as well, which could be one contributing factor to the explain why bankruptcy rates actually seem to decrease (rather than increase) with age.

Portfolio Depletion: Planning For Spending Adjustments Vs Bankruptcy

The key point to this discussion is that spending down a portfolio may make a retiree more susceptible to bankruptcy, but doesn’t necessarily ensure bankruptcy or total financial ruin (especially with Social Security and Medicare safety nets). In fact, the data shows that despite the natural rising risk of depleting assets as retirees age, the bankruptcy rate actuallydecreases among older retirees. Which has implications for both retirees, and the financial advisors working with them.

First, the data suggests that retirees are more capable of making adjustments than traditional financial planning models assume. We know a wide swath of people are underprepared going into retirement relative to what most financial planning models would assume they need. Yet, very low rates of bankruptcy indicate that people are somehow managing to get by. Which means models that project probabilities of “failure” really should be viewed more as probabilities of “adjustment” that real-world retirees routinely make.

Still, this does raise some interesting questions. If retirees are more adept at making adjustments than financial planning models given them credit for, then where are retirees cutting their spending? Are traditional models underestimating how much spending naturally declines later in life? Are generational transfers picking up some of the slack (i.e., children pitching in to support their parents in their later years)? What role are social insurance programs playing in protecting households, perhaps even after they have already reached a financially fragile state? Is the safety net of Medicare and Social Security more effective than what most financial planners give it credit to be?

Additionally, the lack of bankrupt retirees raises some questions for how advisors plan and communication with clients. Should we reframe how we talk about Monte Carlo analyses, focusing even more on probability of “adjustment” rather than probability of failure? Do we need tools which better allow financial advisors to model declining spending throughout retirement? Should reducing financial fragility receive more focus as a pre-retirement planning objective? How would planning advice change if the objective was re-framed as managing one’s financial affairs within a financially fragile state, rather than just focusing on avoiding financial ruin in the form of “bankruptcy” (which seems to rarely result, even after a portfolio has been depleted).

The bottom line is that given how rare bankruptcy in retirement actually is, perhaps it’s time to stop planning on how to avoid bankruptcy and “financial ruin” in retirement, and instead plan to manage the risk of future (downward) spending adjustments and to avoid fragility (as it is fragility that results from a depleted portfolio—not bankruptcy).

So what do you think? Why are bankruptcy rates so low among retirees? Should advisors frame retirement failure differently? How do you talk to your clients about failure in retirement? Please share your thoughts in the comments below!


Risk Composure: The Real Predictor Of Who Can Stick To Their Investment Plan

Risk Composure: The Real Predictor Of Who Can Stick To Their Investment Plan

Executive Summary

Regulators around the world require financial advisors to assess their clients’ risk tolerance to determine if an investment is suitable for them before recommending it. For the obvious reason that taking more risk than one can tolerant will potentially lead to untenable losses. And even if the investment bounces back, an investor who loses more money than he/she can tolerate in the near term may sell in a panic at the market bottom, and miss out on that subsequent recovery.

Yet the reality is that many investors end out owning portfolios that are inconsistent with their risk tolerance, and it’s only in bear markets that they seem to “realize” the problem (which unfortunately leads to problem-selling). Which raises the question: why is it that investors don’t mind owning mis-aligned and overly risky portfolios until the moment of market decline?

The key is to recognize that investors do not always properly perceive the risks of their own investments. And it’s not until the investor’s perceived risk exceeds his/her risk tolerance that there’s a compulsion to make a (potentially ill-timed) investment change.

Yet the fact that investors may dissociate their perceptions of risk from the portfolio’s actual risk also means there’s a danger than the investor will misperceive the portfolio risk and want to sell (or buy more) even if the portfolio is appropriately aligned to his/her risk tolerance. In other words, it’s not enough to just ensure that the investors have portfolios consistent with their risk tolerance (and risk capacity); it’s also necessary to determine whether they’re properly perceiving the amount of risk they’re taking.

And as any experienced advisor has likely noticed, not all investors are equally good at understanding and properly perceiving the risks they’re taking. Some are quite good at perceiving risk and maintaining their composure through market ups and downs. But others have poor “risk composure”, and are highly prone to misperceiving risks (and thus tend to make frequently-ill-timed portfolio changes!).

Which means in the end, it’s necessary to not only assess a client’s risk tolerance, but also to determine their risk composure. Unfortunately, at this point no tools exist to measure risk composure – beyond recognizing that clients whose risk perceptions vary wildly over time will likely experience challenges staying the course in the future. But perhaps it’s time to broaden our understanding – and assessment – of risk composure, as in the end it’s the investor’s ability to maintain their composure that really determines whether they are able to effectively stay the course!

Risk Perception And Portfolio Changes

It is a requirement of financial advisors around the world to assess a client’s risk tolerance before investing their assets, based on the fundamental recognition that not everyone wants to take the same level of risk with their investments. Which is important, because a mismatch – where the investor takes more risk than he/she is willing to take – creates the danger that the investor will lose more money than they are willing to lose in the event of a bear market. And even if the market recovers, there’s a risk that the investor will sell at the market bottom in a panic along the way.

Of course, if all investors were always astutely aware of their own risk tolerance, and the amount of risk being taken in the portfolio, the need to assess risk tolerance would be a moot point, as investors could simply “self-regulate” their own portfolio and behaviors. The caveat, though, is that not all investors are necessarily cognizant of their own risk tolerance comfort level, and/or face the risk that they will misjudge the amount of risk in their portfolio, and not realize the problem until it is too late.

Thus why the key problem is that investors often sell at the market bottom. Because it’s the moment the investor realizes that they were taking more risk than they were comfortable with, and decides to bail out. Not during the bull market that may have preceded it, because when markets are going up, investors don’t necessarily perceive the risks along the way. In other words, it often takes a bear market (or at least a severe “market correction”) to align perception with reality (as until that moment, ignorance is bliss).

The reason why this matters is that it really means it’s not the mere fact that an investor is allocated “too aggressively” that creates behavioral problems like selling out at the market bottom. Instead, the problem occurs at the moment the investor perceives that reality – e.g., during a bear market decline – and then feels compelled to act. Which is unfortunate, because in practice that’s usually the worst time to do something.

Nonetheless, the key point remains that it’s not actually “investing too risky” that creates the problem for the conservative client. It’s the moment of perceiving and realizing that the portfolio is too risky that actually causes a behavioral response (to sell at a potentially-ill-timed moment).

The Risk Of Misperceiving Risk

The fact that conservative investors don’t sell risky portfolios until they actually perceive the risk they’re taking to be beyond their comfort level is important for two reasons.

The first is that it reveals the key issue isn’t actually gaps between the investor’s portfolio and his/her risk tolerance, per se, but the gap between the perceived risk of the investor’s portfolio and his/her risk tolerance. Again, it’s not merely “investing too aggressively” that’s the problem, but the moment of realizing that you’re invested too aggressively that triggers a behavioral (and often problematic) response.

The second is that it also implies investors could make bad investment decisions even with appropriate portfolios, if they misperceive the risk they’re taking!

For instance, imagine a client who is very, very conservative, and doesn’t like to take much investment risk at all. But it’s 1999, and he’s just seen tech stocks go up, and up, and up. Every year, tech stocks beat cash and bonds like clockwork, to a very large degree. And it’s happened so many months and years in a row, that the client is convinced there’s “no risk” to investing in tech stocks – since as he’s seen, they only ever go up, and never go down!

In this context, if you were a very conservative (bond) investor, and became convinced that tech stocks were going to beat cash every year and it was a “sure bet”, what would you do as a very conservative investor? You’d put all your money in tech stocks!

Of course, once tech stocks finally crash the following year, and it becomes clear they’re not a superior-guaranteed-return-alternative to cash, the conservative investor will likely sell, and potentially for a substantial loss.

But the key point is that the investor didn’t suddenly become more tolerant of risk in 1999, and intolerant a year later when the tech crash began. It’s because the investor misperceived the risk in 1999 (causing him to buy), and then adjusted his perceptions to reality when the bear market showed up in 2000 (causing him to sell). It’s the same pattern that played out with housing in 2006, and tulips in 1636. In other words, it’s not risk tolerance that’s unstable, but risk (mis)perceptions.

Similarly, imagine a client who is extremely tolerant of risk. She’s a successful serial entrepreneur, who has repeatedly taken calculated high risks, and profited from them. Her portfolio is (appropriate to her tolerance) invested 90% in equities.

But suddenly, a major market event occurs, akin to the 2008 financial crisis, and she becomes convinced that the whole financial system is going to collapse.

As a highly risk-tolerant investor, what would the appropriate action be if you were very tolerant of risk, but convinced the market was going to zero in a financial collapse? You’d sell all your stocks. Even as a highly risk tolerant investor.

Not because you aren’t comfortable with the risk of all those stocks. But because even if you’re tolerant of risk, no risk-tolerant investor wants to own an investment they’re convinced is going to zero!

But the key point again is that the investor’s risk tolerance isn’t changing in bull and bear markets. She remains highly tolerant of risk. The problem is that her perceptions are changing… and that it’s her mis-perception that a bear market decline means stocks are going to zero (not just declining before a recovery) that actually causes the “problem behavior”. Because it leads the client to want to sell out of a portfolio that was actually appropriately aligned to her risk tolerance in the first place!

Risk Composure – The Stability Of Risk Perception

Every experienced advisor is aware of a small subset of his/her clients who are especially prone to making rash investment decisions. They’re the ones who send emails asking whether they should be buying more stocks every time the market has a multi-month bull market streak. And they’re the ones who call and want to sell stocks whenever there’s a market pullback and the scary headlines hit CNBC and the newspapers.

In other words, some clients have especially unstable perceptions of risk. The cycles of fear and greed mean that most investors swing back and forth in their views of risk at least to some degree. But while the risk perception of some clients swings like a slow metronome, for others it’s more like a seismograph.

Or viewed another way, it’s those latter clients who seem to be especially prone to the kinds of behavioral biases that cause us to misperceive risk. They are especially impacted by the recency bias, where we tend to extrapolate the near-term past into the indefinite future (i.e., what went up recently will go up forever, and what went down recently is going all the way to zero!). They may also be prone to confirmation bias, which leads us to selectively “see” and focus on information that reaffirms our existing (recency) bias. And for many, there’s also an overconfidence bias that leads us to think we will know what the outcome will be, and therefore want to take action in the portfolio to “control” the result.

In essence, some clients appear to be far more likely to be influenced by various behavioral biases. Others are better at maintaining their “risk composure”, and not having their perceptions constantly fluctuate with the latest news nor becoming flustered by external events and stimuli.

Which is important, because means that it’s the clients with low risk composure who are actually most prone to exhibit problem behaviors… regardless of whether they’re conservative or aggressive investors!

After all, an aggressive client with good risk composure may see a market decline as just a temporary setback likely to recover (given market history), while an aggressive client with bad risk composure may see a market decline and suddenly expect it’s just going to keep declining all the way to zero.

In this case, both are aggressive. For both, the “right” portfolio is an aggressive one, given their risk tolerance (and presuming it aligns with their risk capacity). But the client with bad risk composure will need extra hand-holding to stay the course, because he/she is especially prone to misperceiving risk based on recent events, and thinking the portfolio is no longer appropriate (even if it is).

How Low Risk Composure Makes Tolerable Portfolios Seem Scary

Similarly, if two clients are very conservative but have different risk composures, the one with high risk composure should be able to easily stay the course with a conservative portfolio and not chase returns, recognizing that even if the market is going up now, it may well experience market declines and volatility later. While the conservative client with bad risk composure is the one most likely to misperceive risk, leading to rapid buying and selling behavior, as he/she becomes convinced that a bull market in stocks must be a “permanent” phenomenon of guaranteed-higher-returns and overinvests in risk… only to come crashing back to reality (and selling) when the market declines.

The key point here is that both conservative and aggressive clients can have challenges staying the course in bull and bear markets. Even if their risk tolerance remains stable. Because some people have more of an ability to maintain their risk composure through market cycles, while others do not. And it’s those low risk composure investors, who are more likely to misperceive risks – to the upside or the downside – that tend to trigger potentially ill-timed buying and selling activity. As they’re the ones most like to perceive that their portfolio is misaligned with what they can comfortably tolerate (due to that tendency to rapidly misperceive risk in either direction!).

Can We Measure Risk Perception And Risk Composure?

From the proactive perspective, the reason that all of this matters is that if we can figure out how to accurately measure risk perception and risk composure, we can identify which investors are most likely to experience challenges in sticking to their investment plan in the future.

Recognizing that it’s not merely about the investor’s risk tolerance and whether he/she is conservative or aggressive with a properly aligned portfolio in the first place… but how likely he/she is to recognize the risks in the portfolio, and that that portfolio is the properly aligned one! And the potential that the investor will misperceive the risk in their portfolio and think they need to buy more or sell out, even if the portfolio is the right one, because the investor has low risk composure and is constantly misperceiving the risk in the portfolio!

Notably, this is also why it’s so crucial to start out by using a psychometrically validated risk tolerance assessment tools in the first place (though unfortunately, few of today’s risk tolerance questionnaires are even suited for the task!).

For instance, imagine two prospective clients come into your office. Both have aggressive portfolios, and say they’re very comfortable with the risk they’re taking. How do you know if the investors are truly risk tolerant, or if they’re actually conservative investors who have misjudged the risk in their portfolios?

The answer: give them both a high-quality risk tolerance questionnaire, and see if their portfolios actually do align with their risk tolerance.

The key here is not to just ask them about what kinds of investment risks they want to take. Because we already know that if they’re misperceiving investment risk, their answers will be biased towards taking more risk, not because they want to, but because they’ve become blind to it!

In this context, the more “pure” the risk tolerance questionnaire (RTQ), and not connected to investment decisions and market trade-offs, the easier it will be to identify who is actually tolerant of risk, and who might simply be misperceiving (and underestimating) investment risks.

Thus, if the RTQ process is completed, and investor A scores very aggressive, and investor B scores very conservative, it becomes clear that investor A is accurately assessing risk and has the appropriate portfolio, while investor B has become risk-blind and needs a different portfolio (and an education on how much risk he/she is actually taking!)

Of course, the caveat is that a gap between a new client’s risk tolerance and their current portfolio provides an indicator of a current misperception, and helps to determine whether the new client should actually have that aggressive portfolio, or not. And the client who so significantly misperceived risk in the first place ostensibly has poor risk composure – after all, if he/she could misperceive risk so much the first time, there’s clearly an elevated risk it may happen again.

But that doesn’t necessarily provide any indicator of who is most likely to be prone to risk misperceptions and have poor risk composure in the future, if they weren’t already exhibiting those problems.

Accordingly, perhaps it’s time for not only a tool to measure risk tolerance, but also one that either measures risk composure, or at least provides an ongoing measure of risk perception. (As a client where the measured risk perception varies wildly over time is by definition one with poor risk composure, and most likely to need hand-holding in future bull and bear markets to keep their portfolio on target.)

For instance, clients might be regularly asked what their expectations are for market returns. The expected return itself (and especially an inappropriately high or low return) is an express sign of risk misperception, and those whose expected returns for stocks and bonds fluctuate wildly over time would be scored as having low risk composure as well.

Alternatively, perhaps there is a way to ask clients more generally questions that assess ongoing risk perceptions, or simply assess risk composure up front. This might include a biodata approach of asking them whether historically they’ve tended to make portfolio adjustments in bull and bear markets (which at least would work for experienced investors), or whether they like to take in current news and information to make portfolio changes, or other similar behavior patterns that suggest they are more actively changing risk perceptions with new information and therefore have low composure.

The bottom line, though, is simply to recognize and understand that in times of market volatility, what’s fluctuating is not risk tolerance itself but risk perception, and moreover that risk tolerance alone may actually be a poor indicator of who will likely need hand-holding in times of market volatility. After all, if it was “just” about risk tolerance, then any investor whose portfolio was in fact aligned with their tolerance should be “fine” in staying the course. But in reality many clients aren’t, not because their portfolio is inappropriate for their tolerance, but because they misperceive the risk they’re taking, causing them to either want to buy more (in a bull market that seems like a sure bet), or sell in a bear market (because who wants to own an investment you believe is going to zero, regardless of your risk tolerance).

Of course, a portfolio that is not aligned to the investor’s risk tolerance will clearly be a problem. But the missing link is that even for those with proper allocations, those with low risk composure will still struggle with their investment decisions and behaviors! And to the extent we can figure out how to identify clients who risk perceptions are misaligned with reality, and who have low risk composure and are prone to such misperceptions, the better we can identify who will actually be most likely to need help (via a financial advisor, or other interventions) to stay the course!

So what do you think? Is the real problem that some investors are risk tolerant and others are not? Or that some investors are better at maintaining their risk composure, while others are more likely to have their risk perceptions swing wildly with the volatility of the markets? Would it be helpful to have a tool that measures not just risk tolerance, but risk composure? Please share your thoughts in the comments below!

Social Security COLA Could Get Wiped Out By Rising Medicare Costs

Social Security COLA Could Get Wiped Out By Rising Medicare Costs

With the latest CPI release for August now available, analysts project that the annual Social Security Cost-Of-Living Adjustment, or COLA (which is calculated annually from the beginning of September from the prior year to the end of August of the current year), should be approximately 1.8% in 2018, which would actually make it the largest COLA since 2012 (when it was 1.7%), and up substantially from 0% in 2016 and just 0.3% in 2017. However, because the past two years have had especially low inflation and small COLAs, most Social Security recipients have benefitted from the so-called “Hold Harmless” provisions that cap their Medicare Part B premiums at the dollar amount increase in annual Social Security payments – which meant with near-zero inflation for two years, the $104/month Medicare Part B premium from 2015 has risen to “just” $109/month (while the roughly 30% of Medicare enrollees not protected by Hold Harmless have been paying $134/month, plus any income-related surcharges). Yet with inflation now looming for 2018, the rise in Social Security payments next year will be enough to “unwind” the prior Hold Harmless rules, reverting most Social Security recipients from $109/month to $134/month in Medicare Part B premiums, which ironically will consume most or all of their pending 1.7% COLA increase. On the other hand, higher income individuals, who were not eligible for Hold Harmless in the first place and were already paying the full $134/month in Medicare Part B, will continue to pay the same amount next year (albeit plus income-related surcharges again), but actually will see the 1.7% COLA increase in their Social Security checks!

Market Downturn Fears, Other Hot-Button Issues Divide RIA Dealmakers

Market Downturn Fears, Other Hot-Button Issues Divide RIA Dealmakers

This past week was the annual “Deals & Dealmakers Summit” hosted by Echelon Partners (which providers investment banking, management consulting, and valuation services for advisory firms). The conference is known for bringing together most of the leading firms engaged in Mergers & Acquisitions for independent advisory firms, and featured extensive discussion about current trends in advisory M&A. Weighing heavily on everyone’s minds is the potential risk of a bear market – given that the current bull market cycle is more than 8 years long – and what that might do to advisory firm valuations. The prevailing view is that a potential stock market reversal will not likely hurt M&A valuations (or at least, valuation multiples), though buyers are increasingly careful of how they structure M&A deals to not “over-value” companies that could experience a substantial “near-term” revenue decline if a bear market unfolded shortly after the deal closed. On the other hand, the clearer trend is that the most robust demand for advisory firm acquisitions continues to be for “larger” advisory firms – those with more than $1B of AUM, or more specifically with at least $3M of revenue – as larger firms are not only “large enough” to attract deep-pocketed buyers (whereas smaller deals are “too small” to be material for them), but are also more likely to be professionally managed (and less dependent on founders or a single key employee) and better able to leverage economies of scale. Another key trend expected to continue – the ongoing wirehouse breakaway broker trend, although notably “older” brokers (in their 50s or beyond) appear increasingly likely to stick out the remainder of their careers at wirehouses, while it’s younger wirehouse advisors in their 30s and 40s who are increasingly looking to independent channels.

Setting Proper Client Minimums: AUM Account Vs Retainer Fee Minimums For Advisors

Setting Proper Client Minimums: AUM Account Vs Retainer Fee Minimums For Advisors


Setting proper client minimums is an important practice management issue that every advisor needs to consider. For many advisors, the idea of having “minimums” is an unpopular, as their goal is to be ready and willing to serve any prospective client who needs help. But the truth is that there’s only so much time in the day – which means not everyone can be served – and given the overhead costs to operate an advisory firm, serving clients that are “too small” may well be a money-losing proposition for the business (even if it brings some revenue in the door).

Of course, even for advisors who are ready to set client minimums for their advisory firm, it’s one thing to say “you should have minimums”, and another to figure out how to actually structure the minimum (e.g., a minimum account size, or a minimum advisory fee?), and what level it should be set at!

In this week’s discussion, we discuss best practices in how advisors should actually go about setting client minimums, the benefits and trade-offs in setting minimums based on investment account sizes (e.g., an AUM minimum) versus a minimum fee (e.g., a minimum annual retainer), and how to figure out what the minimum revenue per client should be for the business to be profitable.

Most advisors that have a minimum simply set a minimum AUM requirement (i.e., a minimum household or portfolio account size). The virtue of having an asset minimum to work with a client is the sheer simplicity. If the advisor sets an asset minimum of $250,000, and charges a 1% advisory fee, then the advisor has effectively set a $2,500 minimum fee for clients. Additionally, the advisor has set a minimum without any special billing requirements or complexities.

By contrast, some advisors prefer to set a minimum annual fee instead (regardless of account size), such as $2,500/year, and simply charge all clients that fee at a minimum (either as an annual retainer, or sometimes billed quarterly or even month). The good news of such a retainer-fee minimum structure is that it opens up new markets – for instance, young professionals who have limited assets but high income and good wealth-building potential who can happily afford the fee from their income. The bad news, though, it that it introduces additional billing complexity, as now the advisor needs a way to invoice, track, and process those minimum fees and have a way to actually get paid by the client (especially if there is no investment account to manage and sweep fees from!).

Regardless of the structure, though – an annual $2,500 minimum fee, or a $250,000 account minimum at a 1% rate that adds up to $2,500/year – it’s still necessary to determine what the minimum revenue should be, and whether any particular advisor needs a minimum revenue per client that is higher or lower than $2,500/year.

Ultimately, most advisory firms do this one of two ways. The first option is to set the minimum fee based on the cost to actually service a client in the first place, by adding up the total overhead cost of the business and dividing by the number of clients; for instance, if the firm has 180 clients and the total cost of overhead is $450,000, then the firm must charge $2,500/year just to cover its office rent, staff, and other overhead costs. The second option – especially popular for solo financial advisors – is to price the minimum is based on the value of the advisor’s time (since that is his/her primary constraint as an individual advisor). Thus, if the advisor wants to earn $200,000 per year and can only generate about 1,200 productive client-facing hours, the advisor needs to earn at least $166 per hour when doing client work, which means if a client takes 12 hours per year to serve, the minimum fee must be $166/hour x 12 hours = $2,000/year.

The bottom line, though, is that some minimum level of revenue per client is necessary for an advisory firm to execute well as a business. It can be administered as either a minimum account size, or a minimum retainer fee, though each has its benefits and disadvantages and who the advisor can (or cannot) work with, and it’s especially important to recognize that if the advisor is going to have a non-investment-account retainer minimum, the advisor had better be delivering some real financial planning value outside of the investment account!

Welcome, everyone! Welcome to Office Hours with Holman Skinner.

For this week’s Office Hours, I want to talk about a very simple but very important issue that every advisor needs to consider: setting proper minimums for who you will work with as a client.

I know this is an unpopular topic with some advisors who believe we should always stand ready to serve anyone who needs our help, but the truth is that there’s only so much time in the day, and you can’t serve everyone. And serving clients has a cost even beyond just your time. There are regulatory compliance costs, there are staffing and service costs, and the larger your advisory business grows, the more all this matters. But it’s one thing to say, “You should have minimums,” and another to figure out how to actually structure a minimum and what it should be.

Executing A Minimum Annual or Quarterly Retainer Fee 

There are actually some important tradeoffs in deciding between asset minimums and simply having flat fee minimums, like a quarterly retainer fee. So I wanted to tackle this for this week’s Office Hours. The virtue of having an asset minimum to work with a client is the sheer simplicity. If you set an asset minimum of $250,000 and you charge a 1% advisory fee, then you’ve effectively set a $2,500 minimum fee for clients, but it doesn’t require a special billing process, you don’t have to slap them in the face with the saliency of your fee or any other explanation about your minimum fees. You simply have an account minimum or at least a household minimum.

As long as we manage $250,000 or $500,000 or $1 million or whatever you set your minimum account size at, we can work with you and provide you with all of our investment management and financial planning and other services, because we know we’ll be able to collect the fee that it takes to serve the client profitably based on the costs and the business model. And clients either have that amount of assets ready and available to transfer to manage, for you to work with, or they don’t. That’s that. It’s a very simple way to create a process around minimums.

Now, the contrast is having a minimum retainer fee, and that’s a little bit different. To be fair, I suppose it’s still pretty simple to explain. Instead of saying, “We have a $250,000 account minimum and we charge 1%,” you can just say, “We have a $2,500 minimum fee,” period. There it is. That’s the number. The caveat, though, is that while that’s rather simple to explain, in practice it’s actually a little bit more complex to execute. And the reason is that, now if you’re going to do that process, you actually need a way to bill retainer fees. If you also manage an investment account for a client, you may be able to bill the investment account. But if the investment account is relatively small compared to the size of your minimum fee, you may actually set off red flag compliance warnings.

Most broker-dealers and even a lot of custodian systems will, at a minimum, make an inquiry to you if you start charging a $2,500 minimum fee to a client who has less than a $100,000 account with you because it’s a 2.5% fee relative to the account. And that’s a warning sign for a lot of broker-dealer and custodian systems. Now, you may be able to justify and explain the fee based on all the financial planning value you’re providing outside of the investment account. It’s not necessarily that it’s an inappropriate fee in the end, but at least, it’s likely going to trigger some questions, and there may be some broker-dealers that just outright prohibit it. They don’t even want to make the exception for you. They just don’t want to see any fees out of any account that are larger than X%.

And, at a minimum, you’ll likely have to become an IAR (an investment advisor representative) of the broker-dealer’s corporate RIA just to charge any kind of minimum retainer fee if you’re not already tucked up under their RIA. And many corporate RIA’s aren’t even structured to allow retainer fees. They’re only built for AUM fees (assets under management fees), which makes this impossible unless your broker-dealer changes its corporate RIA policies or you decide to leave and form your own independent RIA to do this.

And the process gets even messier if you’re working with a client who doesn’t have available assets to manage. Maybe it’s a young doctor making $300,000 a year and still has over $100,000 in student loan debt who will happily pay $2,500 per year for non-investment advice, because they have the financial wherewithal, but can’t have it billed from an investment account because the doctor doesn’t have one. So now you need a process to bill the client directly, either by writing a check, but now you need to get the check, track outstanding invoices, make sure all the checks are written, actually deposit the check to get paid, reconcile the checks in QuickBooks, or do it electronically with maybe an ACH bank transfer or a credit card… but now you need technology to process that payment.

Now, in point of fact, we’re actually in the process of launching a new payment processing platform for advisors called AdvicePay, specifically to help support advisors who want to do this kind of retainer fee billing from a bank account or a credit card, for when the client doesn’t have an investment account to manage that you can sweep the fee from. But the point is that it’s crucial to consider when you’re choosing between AUM account minimum or a retainer fee minimum. What is your plan to actually execute the billing process for that minimum, especially if it’s a retainer fee minimum and particularly if that retainer fee can’t fit the traditional investment account billing process because the client won’t have assets to manage?

And that’s also true even if you’re going to have the retainer fee minimum but keep your AUM structure because you need a way internally to track when a client switches from the retainer fee minimum to the AUM fee once the account is big enough. If your fee is 1% of assets with a $2,500 fee minimum, you need a system in place to switch from the $2,500 fee minimum to the 1% of assets when the client’s account actually crosses over $250,000, or a regulator’s going to get very unhappy that you’re misbilling your clients. So now you need tracking to go from one to the other, and not that that’s impossible, but just to recognize there are real-world business execution issues you have to consider when you’re choosing these fee structures.

Choosing Between AUM Account Vs Retainer Fee Minimums [6:30]

Beyond just having a plan about how to execute either an AUM account size minimum or a retainer fee minimum though, the broader question is which is better for running an advisory business? And here there are a few issues to consider as well. First and foremost, recognize that as long as you have an AUM account minimum, you will always be constrained to people who have assets to manage as your target market. Now, if you’re in the business of managing portfolios, that makes sense. You manage portfolios, you need people who have portfolios to manage. AUM account minimums work great. But if your primary focus is financial planning, and you simply offer investment management along with it as one of your services, and get paid through AUM fees just because it’s so straightforward to execute as a billing process, recognize that using an asset minimum, you will exclude clients who might have happily paid for your advice, but just want to pay for your advice, and not have you manage their portfolio.

For instance, the doctor example I mentioned earlier… this high-income doctor with student loans. If you’re a great comprehensive planner for upwardly mobile young professionals like this and you can give advice about student loans and employee benefits and negotiating compensation and cash flow and budgeting, and all the other things that are valuable to this client, the doctor may happily pay you that $2,500 a year fee for advice. But if you have an AUM account minimum, you can’t work with this doctor under any circumstance, because there’s no account to manage, nor is the doctor looking for that service. If the doctor had assets, but they’re tied up in the 401(k) plan he’s still working at and can’t roll it over, you still have this problem unless you’re using a retainer fee model because then you don’t need the AUM to work with a doctor. You simply bill a minimum fee for whatever that level is, and he has the income to pay it directly without being billed from the investment account.

This is actually why I think the industry trend towards minimum retainer fees is so interesting because it opens up new groups to work with. Because now it doesn’t matter whether the prospective client has an account to manage or not. As long as the person finds some value in your advice and has some financial wherewithal to pay for it, even if it’s directly from personal income, you can work with them with a retainer fee minimum but not an account size minimum.

The Monthly Retainer Model In Financial Planning by Alan Moore And Michael KitcesFor the simplicity of billing, I know some firms that just do an annual retainer fee in this case, so you don’t have to handle checks four times a year. Others prefer to do it quarterly simply because it makes the payments smaller and more bite-sized and easier to pay for the client. In fact, with AdvicePay, we see most of ours at XY Planning Network who work with younger clients do minimum retainer fees, and they charge it as a monthly retainer fee, so that the client just pays the fee directly from their income through bank account ACH transfer or even a credit card, and it’s just another monthly fee like their gym membership and Netflix account and smartphone data plan.

But the key point is that while there may be some administrative complexity with retainer fee minimums because you need a different billing process. Retainer fee minimums also open up new markets, particularly groups like young professionals with limited assets, but good income and good wealth-building potential when you give them a means to pay you directly from their income instead of the assets they don’t have yet. But that only works if you actually have a value proposition that’s built to go beyond the portfolio. Otherwise, they’re going to say, “Why would I pay you for investment management? I don’t have investments to manage.”

At the same time, it’s worth noting that for the more affluent prospective clients, the more likely it is that they’ll actually have enough assets to manage anyway. And as a result, when we actually look at the industry benchmarking studies on this, the larger the advisory firm and the more affluent its clientele are, the less likely they are to use retainer fee minimums, and the more likely they are to simply have AUM account size minimums. If you’re working with multi, multi-millionaires, just a $1 million asset minimum is not such a big deal for really affluent clients. For the rest of us, though, that don’t necessarily work with super wealthy, where big accounts are out there and it’s easy to hit sizeable minimums, using a minimum retainer fee appears to be more popular. It lets us ensure some minimum level of revenue per client that we need to have to run a healthy business, but doesn’t exclude people who want to pay for our advice and just don’t have assets available to manage.

Setting Your Minimum Fee Based On Time Or Cost Of Service [10:42]

All that being said, though, it does still leave open one other important question, which is how do you actually set the minimum fee? And whether it’s going to be a percentage of some minimum AUM account size or a flat dollar amount billed annually or quarterly or monthly, you still need to actually set the minimum dollar amount. Now, I find most advisory firms tend to do this one of two ways. The first is to set your minimum fee based on the cost to actually service a client in the first place, and this is especially important once you have several staff members in place as a growing advisory firm.

As a starting point, pull out your business’ profit and loss statement from last year and add up the cost of overhead. Your office rent, your admin staff cost, your technology cost, everything it takes to keep the lights on and the doors open to run your firm. So let’s say last year your firm did $1.2 million in revenue across 180 clients that you and an advisor partner are serving. Your total staff and overhead costs last year were about $450,000. That includes a couple of staff members, your rent, your technology, compliance, consultant, everything together. So if you have $450,000 of total overhead across 180 clients, that means your raw overhead per client is $2,500 per client per year, which means, at a bare minimum, you need to be generating at least $2,500 of revenue per client, or otherwise the fees aren’t even covering the overhead to run the business. So if your AUM schedule is 1%, you’d have a $250,000 minimum. If your advisory fee is 1.3% for smaller clients, you could have a $200,000 minimum or you might just set a minimum retainer fee of $2,500 a year or even $200 a month, whatever it takes to make the math work.

Now, that’s just for covering overhead. As the advisor and owner of the business, you’re not making any money yet. If we assume that you and your advisor partner are paid $175,000 a year for servicing your clients, you know, you pay yourselves a fair market salary for the job you do in the business, then your total cost for clients in the business is $450,000 for overhead, $350,000 for two advisors, or $800,000 total, which means across 180 clients, it takes about $4,400 a year to get paid for what you do. Which means your minimum fee needs to be at least there, ideally with a reasonable profit margin on top. So maybe you set a minimum client fee of $4,500 or $5,000 a year, which then again you can make a $5,000 annual fee minimum or a $500,000 account size at 1% or $400 a month ongoing monthly retainer fee, which gets you pretty close. But the key point is that you’ve set the fee high enough to ensure you’re actually covering the costs to run the business profitably.

Now, for those of you who are solo advisors, maybe you’re running independently as an RIA or you’re an independent advisor on a broker-dealer platform or you run your practice on your own, this kind of allocate the overhead across the clients approach doesn’t make a lot of sense, because you’re a solo that doesn’t have a lot of overhead. I mean, your primary constraint is your time. So if your primary constraint is your time, then the way you should base your minimums is the value of your time. So if your goal is to earn $200,000 next year, there are about 2,000 working hours in a year, just assuming 40-hour workweek, 50 workweeks in a year with a little vacation, which means you need to earn $100 an hour for your time to make this work.

Now, the reality is that not all of your time will be client-facing, billable time though. You may only have 1,200 or 1,500 hours a year of client-facing time because you also have to take the time to run the business, maintain your continuing education, read really long “Nerd’s Eye View” blog posts, and so if you want to earn $200,000 a year and you can only generate about 1,200 productive client-facing hours, you actually need to earn $166 an hour to make this math work. Which means if you take 12 hours a year to service a client based on maybe 3 2-hour meetings each year plus an hour of prep time for each meeting, plus a few hours of miscellaneous questions and service issues that come up, if it takes you 12 hours a year and you need to generate $166 an hour, then your minimum revenue per client is $2,000 per year. And now you can set your AUM account size minimum or your retainer fee minimum based on the right number to get you to your income goals for the practice.

Instituting A New Minimum Fee For Your Existing Clients [14:56]

If you’re doing all this as a new advisor just getting started, as I think Paul was asking at the beginning, the reality is that you’ll have to do it based on allocation of your time, because you don’t have the rest of the staff and overhead structure yet to allocate costs. But I know for most advisors who listen to this, you may already have an advisory practice or in a larger business and already have clients and staff, which means you can actually go through the math of this exercise and figure out what does it cost for you to actually deliver your services profitably to a client, and then revisit whether you need to make changes for your existing business. Because if you go through this exercise to determine the minimum revenue per client that you should be getting to run profitably and then look at all your clients, you are almost certainly going to find that some of them don’t meet the minimums, which means it’s time to implement minimum fees in your practice.

For those who want a full discussion about raising fees on existing clients, it’s kind of beyond our scope today. You can check out some of our prior Office Hours videos on the blog where I’ve specifically talked about how to do this. But the basic gist is that first you need to figure out what the minimum fee should be, then you need to decide how it’s going to be structured. Is it an account size AUM minimum or a retainer fee minimum? Then you need to go back to all your clients who don’t meet the minimum and explain, “In assessing what we do to service all of our clients like you, we’ve determined that it takes a minimum of $X”, ($2,000 a year, $5,000 a year, or whatever it is), “to deliver our best value to clients. Unfortunately, right now the size of your account or your assets does not meet the minimum that it takes for us to do our best work for you. So as a result, going forward, we’re going to be instituting a new minimum. We’d love to keep working with you at this new fee level, and if you don’t think we’re a good fit anymore, that’s okay, too. We’ll work with you to find a new advisor who’s a better fit.”

When you do this, you will lose some clients. Many, you’ll find, actually will step up and pay your minimum, particularly if it’s a retainer fee minimum and they just get to choose to pay you if they feel you’re worth the value. They don’t even have to move other assets. But some clients will say no. But again, since you already figured out what the fee is that’s necessary to cover the costs of the business and your time and be profitable, by definition, the only clients you’ll lose in this process are the ones who were losing you money anyway. And their departure just gives you more capacity to serve the clients who can meet your minimums and will better value the value you deliver. But the bottom line here is that you really can do this with either an account size minimum for clients or a minimum retainer fee. Either works, but there are tradeoffs in who you can and cannot serve with each type of minimum, and the kind of value you have to deliver to justify that minimum. Because again, if you’re going to have a non-investment account retainer fee minimum, you better be delivering some real financial planning value outside of the investment account to justify it.

And bear in mind the differences in just who you can work with as account size minimums are naturally simpler, do fit most advisors’ existing business models, but does limit you to working with people who have assets (i.e., not just those who are willing and ready to pay your fee), which indirectly can end up skewing your client base towards older retirees and away from younger clients who may be good for the business in the long run. And you have to have a plan for how you’re actually going to execute the fee, particularly if you’re going to move away from kind of an industry standard AUM fee, and towards a retainer fee which necessitates some different billing structures.

I hope this is helpful as food for thoughts. This is Office Hours with Holman Skinner. We’re normally 1:00 p.m. East Coast time on Tuesdays. Unfortunately yesterday I was tied up in meetings, so here we are on Wednesday this week, but thanks again for joining us, and have a great day!

So what do you think? How do you set your minimum fees? Do you have a process for determining whether clients are profitable? What other differences are there between the AUM and retainer models? Please share your thoughts in the comments below!

Predicting Wealth Building Behavior With DataPoints Assessment Tools

Predicting Wealth Building Behavior With DataPoints Assessment Tools

Executive Summary

The Millionaire Next Door became a NY Times Bestseller in 1996 by revealing how little we understand about millionaires, and the behaviors that help people to become millionaires. While the traditional view was that wealth comes from an inheritance, or becoming an executive in a major corporation, and that you can identify millionaires by their high-end suits, luxury cars, and large houses in affluent neighborhoods, in reality a huge swath of millionaires become such simply by living frugal lives of cheap suits, practical cars, and modest homes, which allows them to convert a substantial portion of their income into wealth over time.

Of course, having a healthy income, and willingness to take calculated risks for success, do clearly help in the wealth-building process. But the key point was that not only is affluence not necessarily correlated to outward signs of wealth, but in reality some of the greatest wealth-building behaviors come from not flaunting that wealth and being “socially indifferent” to trying to keep up with the Joneses.

Now, a company called DataPoints – founded by Sarah Stanley Fallaw, the daughter of The Millionaire Next Door author Thomas Stanley (and herself trained as an industrial psychologist) – is turning The Millionaire-Next-Door insights about wealth building behaviors into a series of assessment tools that financial advisors can use.

For advisors who are trying to expand their practices to work with “younger” wealth accumulator clients, the DataPoints assessment tools provide a unique research-based approach to actually understand which prospects are likely to be successful wealth accumulators, and which prospects should be avoided because the assessment reveals in advance they will be especially difficult to work with. And for new and existing clients, a rigorous wealth building assessment tool as a part of the discovery process can help the advisor understand where to focus their advice and efforts to help the client actually change their financial behaviors for the better.

In other words, while as financial advisors we increasingly find ourselves talking about the “behavioral” value of financial planning advice, DataPoints is actually creating tools that help to measure what a client’s wealth-building behaviors actually are. Which on the one hand makes it easier to be effective with clients – as we can get a better understanding upfront of the client’s financial tendencies – but also makes it possible to actually measure the success of the advisor-client relationship by the extent to which the advisor actually helps their client (measurably) change their financial behaviors and attitudes!

Building Wealth And The Millionaire Next Door Book

The Millionaire Next Door by Thomas Stanley and William DankoIn 1996, Thomas Stanley and William Danko released the book “The Millionaire Next Door”, which quickly became a NY Times Bestseller.

Stanley and Danko were market researchers who had initially sought – as marketers do – to better understand the tendencies, habits, attitudes, and other psychographics of the affluent (a segment of the marketplace that companies have long wanted to better understand). In fact, Stanley had already published several books on working with the affluent, including “Marketing To The Affluent,” “Selling To The Affluent,” and “Networking with the Affluent”, based on nearly a decade of prior research he had conducted through his Affluent Marketing Institute.

Yet Stanley and Danko aimed to go even deeper into understanding the millionaire mindset. Accordingly, they launched a new comprehensive survey of nearly 1,000 affluent individuals in the early 1990s, and conducted interviews with another 500 affluent individuals via focus groups. And the end result of the study revealed that the typical idea of what a millionaire looks like – living in an affluent neighborhood, driving a luxury car, and exhibiting other similar indicators of wealth – is not actually a fair characterization of a huge segment of the affluent.

Instead, it turned out that nearly one-half of millionaires don’t live in upscale neighborhoods. Nor did they commonly inherit, as (at the time) the researchers found that 80% of America’s millionaires are first-generation “rich”. A wealthy individual was simply someone who was able to earn a solid income, and exhibited certain “wealth-building” behavioral traits along the way, that made it especially likely they would be able to convert that current income into long-term wealth.

Specifically, the researchers found that “Prodigious Accumulators of Wealth” (PAWs) tended to have 7 core traits:

– They lived well below their means

– They allocated their time, energy, and money efficiently, in ways conducive to building wealth

– They believed that financial independence is more important than displaying high social status

– Their parents did not provide economic outpatient care

– Their adult children were economically self-sufficient

– They were proficient in targeting market opportunities (i.e., finding/creating wealth-building business opportunities)

– They chose the “right” occupation (one with good income-earning potential)

Of particular note at the time was the recognition of the first three points – that wealth builders tended to be frugal (i.e., live well below their means, and save 20%+ of their income every year), tended not to pursue social status symbols (i.e., are more likely to wear inexpensive suits and jewelry and drive non-luxury American-made cars), and that to the extent they did spend they tended to allocate their dollars differently (e.g., buying cars for the long-run instead of leasing them, owning homes instead of renting them). In other words, being a millionaire wasn’t about inheriting wealth or just earning the big bucks; millionaires were also a sea of frugal tightwads living in modest homes in non-affluent neighborhoods (the very antithesis of the “traditional” view of a millionaire at the time!).

In addition, though, the research did find that millionaires were more likely to proactively create opportunities for themselves – at the time, self-employed people made up less than 20% of workers in America, but accounted for 2/3rds of millionaires (either by being entrepreneurs, or self-employed professionals like doctors or accountants). And affluent accumulators did tend to have pursued above-average-income job opportunities in the first place (though not necessarily of the high-visibility variety, as the millionaires profiled included not only doctors and lawyers, but also welding contractors, paving contractors, and even owners of mobile-home parks).

To some extent, it’s perhaps not “surprising” that those who manage to find above-average job opportunities ended out creating above-average wealth. But the key recognition of the Millionaire Next Door was that above-average income alone does not necessarily lead to above-average wealth, because not everyone translates their income to wealth in the same way (or at all)! Instead, it’s the other behaviors – about being able to live within their means (even or especially when their income could afford a much higher standard of living than what they were currently enjoying), allocate dollars to things that appreciate rather than depreciate, and their “social indifference” to keeping up with the Joneses, that resulted in accumulating wealth and reaching millionaire status.

Which, again, was somewhat “surprising”, because it meant millionaires didn’t look like what most people expected millionaires to look like. They often didn’t live in millionaire-looking homes, drive millionaire-looking cars, or buy millionaire-looking jewelry. Which was actually the point. Because those were the behaviors that led them to not spend as much, and be able to accumulate wealth in the first place!

DataPoints And The Further Study Of Building Wealth

After the success of The Millionaire Next Door, Thomas Stanley went on to conduct further research on the behaviors and psychographics of the affluent, further extending the quantitative and qualitative data on wealth building under the Affluent Market Institute (AMI), and publishing “The Millionaire Mind,” “Millionaire Women Next Door,” and “Stop Acting Rich” to help consumers understand how to better adopt the behaviors and mindset of those who successfully accumulated wealth.

And to better put the research to use in application, in 2013 Thomas Stanley’s daughter Sarah Stanley Fallaw (a researcher in industrial psychology with a Ph.D. in Applied Psychology herself, who had joined AMI in 2009 as its Director of Research) founded DataPoints to begin the process of adapting the research into a series of assessment tools that can be used to evaluate someone’s wealth-building potential.

In the years since, the DataPoints researchers have found that beyond someone’s circumstantial factors that lead to wealth building (i.e., having grown up more financially independent, and having a high-income job), there are a series of distinct and consistent factors that are predictive of wealth building. They are:

– Frugality (one’s willingness and ability to spend below their means);

– Responsibility (to what extent does the person believe they have control over their financial [and other] outcomes, versus whether they are externally determined);

– Confidence (does the person have the confidence to believe they’re capable of improving their situation);

– Planning and Monitoring (can you set goals and effectively monitor your progress towards achieving them)

– Focus (do you have the discipline to avoid distractions and stay on track to your goals); and

– Social Indifference (do you feel a need to spend to display social status, or are you socially indifferent to the spending habits of others)

Combined together, these Wealth Factors help to reveal who is more or less likely to actually convert their income into wealth, which is relevant not only to individuals who may want to improve their situation (and need to understand what behaviors to change), but also to financial services firms who may want to understand who is a “good” potential wealth-building client in the first place.

After all, with the growing shift from focusing on baby boomers (who have already accumulated wealth), to Gen X and Gen Y clients (who are still in the wealth-building phase), it’s especially important to understand whether someone already has the right wealth factors in place to be able to accumulate, or whether there are key behavioral areas that the advisor will need to work and focus on in order to help the client achieve financial success.

Datapoints Engage And Advise Assessment Tools

As currently constructed, DataPoints provides a series of 4 “Engage” and 3 “Advise” modules to better understand an individual’s financial attitudes and habits.

All of the DataPoints tools have been psychometrically tested to affirm their validity and realibility, and the questions that DataPoints asks uses a “biodata” approach, where instead of asking people about their personality (e.g., “are you frugal” or “do you like to spend money on social status”) they’re instead asked about their “personal biography” and to reflect on their past behaviors to understand their traits (e.g., “I live well below my means” [agree or disagree] or “Most of the clothes I buy for myself are:” [trendy / practical / etc]).

Engage Assessments For Prospects

The DataPoints “Engage” questionnaires are a series of relatively short screening-style assessments, containing 10-13 questions and taking no more than about 2-3 minutes to complete, that prospective clients can complete. The four Engage assessments evaluate a prospect’s “Spending Patterns”, “Career Fit”, “Wealth-Building” potential, and their tendency to engage in their own “Financial Planning” and self-monitoring behavior.

The brief questionnaires can be sent as a link directly to a prospect, or even embedded on an advisor’s website, as an opportunity to both add immediate value for a prospect (who might be curious to know how their spending behaviors or wealth building potential stack up), and for an advisor who wants further insight into the client’s potential issues and concerns. The advisor might offer one or several Engage assessments for prospects to try out, depending on which one(s) are a good fit for that advisor’s particular type of target clientele

Advise Assessments For Clients

As contrasted with the Engage assessments, the Advise modules are longer (45 – 54 questions) and meant to go deeper (more likely with new or existing clients).

The first is a “Building Wealth” assessment, which directly measures the six wealth-building factors identified in DataPoints’ research (building on Stanley’s original Millionaire Next Door) behavioral habits. The second is a “Financial Perspectives” assessment, which looks deeper at a client’s financial attitudes, for instance their tendencies towards altruism, budgeting, status, spending, and (financial) independence. And the third is an “Investor Profile”, intended to be DataPoints’ take on financial risk tolerance and the client’s propensity to take financial risks (given that Stanley’s original research clearly showed that Millionaire wealth accumulators are significantly more likely to be willing to take at least calculated risks)

To some extent, the idea that “people who are frugal and don’t try to Keep Up With The Joneses” may seem intuitively obvious (especially since The Millionaire Next Door book itself came out, and also from the experiences that most financial advisors have witnessed first-hand with their clients). Yet until now, financial advisors have lacked a systematic process to make this assessment with clients (and prospects).

But with standardized assessments, it becomes possible to really understand how clients’ wealth-building behaviors compare to one another… and to potentially explore issues that may otherwise be difficult to talk about.

Sample Advise Assessment: Building Wealth

For instance, in putting myself through the Building Wealth assessment profile, it turns out that I have a very high level of confidence and personal responsibility – for better or worse, I believe that I am in control of my own destiny, and am confident in my ability to find positive financial outcomes. In addition, I am rather frugal (having long lived on far less than I make), and I have never been one to try to dress in the latest fashion trends. (Thus the Kitces Blue Shirt phenomenon!)

On the other hand, the assessment tool also correctly identified that I struggle tremendously with Focus (a lifelong battle with ADHD), and that I am not actually very strong in planning and monitoring for my own future (thus why I rely heavily on third-party tools like Mint.com to make it easy for me by automating the necessary tracking!).

Michael's DataPoints Assessment


Notably, though, my “Wealth Potential” score is still strong, despite my moderate score in planning and low Focus score… in part because the DataPoints research has shown that one’s wealth-building capabilities are not merely the additive sum of each factor. Instead, the interrelationships are more complex.

For instance, the DataPoints research notes that for more affluent individuals, an inability to focus may not be as critical, as financial management tasks can be outsourced (via professionals like financial planners, or now increasingly via technology as well). And DataPoints has also found that ironically, clients who are high in Responsibility are more likely to build wealth but also can actually be more problematic in bear markets, as their desire to exert control over their situation (which helps them create wealth) also makes it very difficult for them to sit by and do nothing in the midst of market turmoil (and instead feel a strong need to “do something”, given their tendencies, even when they shouldn’t!).

Financial Planning Applications Of Financial Behavior Assessment Tools

Ultimately, financial behavior assessment tools like the ones that DataPoints has created appear to have two primary applications to aid in the financial planning process.

Screening Prospects With Wealth Building Potential

The first is to use DataPoints’ assessment tools as a form of screening process to identify clients who are likely to be wealth accumulators in the first place.

For those advisors who are trying to work with younger clientele who don’t meet the firm’s current minimums – or in particular, are trying to identify young accumulator prospects who may not be profitable clients now but are likely to be in the future – the Building Wealth assessment tool, or even the shorter Wealth Potential engagement tool, can help give the advisor a better understanding of the client’s long-term potential. Or viewed another way, the Building Wealth assessment tools can help reveal which clients are most likely to be effective at implementing the financial advisor’s advice and recommended strategies – as opposed to those more “challenging” clients, who seem to struggle to follow through on ever implementing the advice that’s given to them

In this context, the advisor might, as a part of their initial “Get To Know You” process, send a DataPoints Building Wealth assessment to the prospective client, with a statement to the effect of “This assessment is meant to help you understand a little more about your own financial habits and tendencies. Please complete it before our first meeting, so that we can have a better understanding of whether or how we can best help you.” Or alternatively, the advisor can actually embed the DataPoints Engage asssesments directly into his/her website, and simply make it available for prospects to take themselves (and then the advisor can decide to follow-up on those who show a strong wealth-building potential, to see if they’re interested in working together).

On the other hand, though, the relevance of the DataPoints assessment tool is not merely about identifying young accumulator clients who have a good potential to actually accumulate. It would also be relevant for older and already-affluent clients, as their scores in areas like “Frugality” and “Social Indifference” can provide a valuable indicator of whether their natural tendencies are to sustain their accumulated wealth, or to dissipate it away.

And the assessment may be especially helpful for those who have had “Sudden Money” events, whether an inheritance, divorce (for the spouse who receives the settlement!), business liquidity event, or other surprise windfall… where the client did not necessarily establish their wealth through the usual accumulation-style means, and as a result it’s not always clear whether – once they achieve their wealth – they are likely to sustain it or not. A DataPoints assessment can help provide that information up front, to better understand where the likely challenges will be with the client.

And notably, DataPoints’ own research has found that not all Wealth Factors types are equally likely to engage a financial advisor in the first place. For instance, their research has found that those who already have a high propensity to accumulate wealth are the least likely to hire an investment manager (as they likely feel the Confidence and Responsibility to manage it themselves). Those who have the least propensity to accumulate wealth are the most likely to seek out a financial planner (ostensibly in recognizing that they need help, though obviously not a good fit for advisors using an AUM model!), and those who have “medium” propensity (recognizing some capabilities, but recognizing the need for some hep as well) who are the least likely to eschew a financial planner and use a robo-advisor instead! On the other hand, all the groups are equally likely to leverage personal financial management technology to help them on their path (and drawing an important distinction between the desire for technology to track finances, and the need for a financial planner about what to do about their finances!)!

Use Of Financial Services Providers By Wealth Building Likelihood

Profiling Clients For Behavioral Finance Coaching Needs

With prospects, it’s necessary to keep the assessment brief, and thus why DataPoints makes its short Engage assessments available. On the other hand, the DataPoints “Advise” tools – which are the longer and more in-depth assessments – could actually be used as a part of the advisor’s data-gathering process once the individual has already agreed to become a client, to truly understand what the client’s natural financial behaviors are, and how best to work with the client.

For instance, those who are low in Focus may need regular guidance and nudges to stay focused on their long-term goals. Those who struggle with “Planning & Monitoring” may be especially interested in the advisor’s regular updates (while those who already score high in that area probably have their own systems for tracking, and won’t care about the advisor’s quarterly reports at all!). Clients with a low social indifference will need constant reminders to focus on their own goals and not what others are doing. Those with low confidence may struggle to implement the advisor’s recommendations, because they aren’t confident in their ability to succeed, while those with high confidence and high responsibility may have trouble staying the course in a bear market and want to intervene (because they feel the situation is in their control, even if it’s not).

The process may be especially helpful for working with couples as well, where the reality is that both spouses do not necessarily align on all of these wealth building behaviors and financial attitudes. In fact, major gaps in areas like social indifference and frugality between a husband and wife may help to explain a lot of financially-related marital strife. While gaps in areas like confidence and responsibility will tend to be a guide about which spouse is likely to be the financial decision-maker in the household, and which tends to be more hands-off in the process.

A New Way To Measure Advisor Behavioral Impact “Success”?

A natural extension of how the DataPoints research might be applied is the recognition that not only do the assessments help provide an indicator of who has the behavioral tendencies and attitudes to accumulate wealth, but they can also be used to track the positive impact of the financial advisor over time, and become an alternative way to measure an advisor’s “success” and quality!

Accordingly, DataPoints has introduced a new “Performance Plan” module that monitors how the client’s financial attitudes and wealth factors change over time in working with the advisor, providing both the advisor and client guidance on particular areas to focus on for improvement, and then tracking that progress (by sending the client periodic assessment updates).

DataPoints Image Of Performance Plan

In this context, not only can the advisor avoid being judged based on whether a portfolio happens to hit benchmark returns or not, but instead moves their value proposition away from market returns and goal progress altogether (recognizing that often setbacks to goals are beyond the advisor’s control anyway, from a sudden health event, to a natural disaster, to a job loss or market decline). The focus of the advisor-client relationship instead becomes, as many advisors already espouse, a focus on “behavioral coaching”, with results that can be tracked and measured (via DataPoints), and a recognition that if the right behaviors and attitudes are in place that are conducive to wealth-building, the wealth itself is likely to come eventually (even if the path remains a bit bumpy in the short run).

Ironically, though, some advisors may be wary of going so far as to measure client’s behavioral attitudes and change over time, recognizing that in the end, we are financial planners, and not trained psychologists. And once you begin tracking a client’s financial behaviors and attitudes, you’re truly accountable – as the advisor – to helping to change them!

Nonetheless, with the rise of behavioral finance, the commoditization of financial services products, and an increasing focus on the intersection of technical financial advice and the empathy, coaching, and behavioral-change skills necessary to help clients actually implement the advice, arguably the DataPoints Performance Plan assessment provides a potential framework for whole new ways that advisors can measure their “success” and “effectiveness” in the future.

At a minimum, though, in a world where a person’s income and outward signs of affluent aren’t necessarily very good indicators of their wealth, nor their propensity to accumulate or sustain the wealth they have, DataPoints provides a new way to deepen the discovery process… whether with a new client to really understand their financial attitudes and behaviors… or to be used as a way to engage prospects and identify those whom the financial advisor is most likely able to help and work with constructively in the first place!

In the meantime, for advisors who want to check it out themselves, the DataPoints Engage and Advise assessment are available now. The Advise module (which includes the comprehensive Building Wealth assessment) is available for $59/month for up to 100 clients, the Engage lead-generation assessments costs $109/month, or a “Complete” package is available for $139/month which includes both. Further information is available on the DataPoints website, and pricing details are found here.

So what do you think? Would a solution like DataPoints be helpful to better understand which clients may be more or less effective at building wealth? Would you use DataPoints as a screening tool to understand which clients will be easiest to work with, or as an ongoing advisory tool to understand which behaviors your clients need help with? Please share your thoughts in the comments below!

Why Aren’t Checklists A Financial Planning Standard?

Why Aren’t Checklists A Financial Planning Standard?

Executive Summary

As financial planning for clients grows more and more complex, it becomes increasingly difficult for planners to recognize every planning issue, opportunity, and concern from memory alone. As a result, there is an rising risk that planners commit malpractice and make a mistake – albeit by accident – in the struggle of trying to apply everything they have learned to an incredibly wide range of client situations.

However, the reality is that this challenge is not unique to financial planning. Many professions face a similar struggle, where the sheer amount of knowledge required, and the incredible number of client/customer/patient situations make it almost impossible to remember everything that’s necessary at the exact time it’s needed, mean a rising risk of mistakes, negligence, and ineptitude.

So what’s the solution to address this challenge? As it turns out, there’s a remarkably simple one: checklists. While it may seem absurd that such a basic device could enhance client outcomes – in fact, as professionals we often bristle at the thought that a checklist could tell us something we don’t already know – it turns out that checklists may be an excellent means to deal with the simple fact that we are all fallible humans.

Unfortunately, though, few checklists currently exist in the world of financial planning, especially outside of the operational aspects of an advisory firm. Nonetheless, it is perhaps time to give checklists the recognition they deserve, as a potentially critical step to ensure that we apply the proper due diligence to each and every complex financial planning situation, and that nothing accidentally slips through the cracks.

The Checklist Manifesto by Atul GawandeThe inspiration for today’s blog post is the book “Checklist Manifesto” by Atul Gawande, a doctor who was the primary driver behind the World Health Organization’s “Safe Surgery Checklist” and who makes a compelling case that checklists should probably be adopted more broadly in all industries and professional services – including financial planning – as a way to deal with the incredible complexity that we face as practitioners.

Ignorance Vs Ineptitude

It’s important to recognize that in many situations, professionals fail simply because the task at hand was beyond saving; we may have tremendous intelligence and technology available to us, but we are not omniscient or all-powerful, and some fallibility is inevitable. However, Gawande notes research by Gorovitz and MacIntyre who find in the medical context that in situations where success or failure is within our control, there are two primary drivers that lead to failure: ignorance, and ineptitude.

Ignorance has been the driving force for failure for most of medical history. Up until just the past few decades, we simply didn’t know what the true causes were for many diseases and maladies, much less how to treat them or fix the underlying causes. For instance, Gawande notes that as recent as the 1950s, we still had no idea what actually caused heart attacks or how to treat them, and even if we’d been aware of contributing factors like high blood pressure, we wouldn’t have known how to treat that, either. If someone had a heart attack and died at the time, it was our collective ignorance of the underlying problems that led to the “failure” to save the patient.

By contrast, in today’s environment, we have developed numerous drugs to treat high blood pressure, as well as heart attacks themselves. We “know” how to fix an astonishing range of maladies. If an ineffective (or even harmful) treatment is applied now, we don’t simply let the professional off the hook on the basis of “well, we didn’t really know what to do, anyway.” In other words, our collective ignorance of how to treat a problem is often no longer an acceptable answer when there is an unfortunate outcome; instead, a failure of the professional is an “error” and a sign of ineptitude.

Of course, the caveat is that many of the professional situations today are of a highly complex nature. While we might understand far more about the body and how to treat it than in the past, it is still remarkably complex, and many “failures” of a medical practitioner still walk a fine line between ignorance, ineptitude, and a situation that was never really able to be saved in the first place. As a result, Gawande notes that we’re more likely to address such situations by encouraging more training and experience for the practitioner, rather than to punish failure, as long as outright negligence was not involved. Unfortunately, though, it’s not clear if more experience and training alone are necessarily sufficient; as our knowledge increases, so too does the complexity of applying it correctly, to the point where we may be reaching our human capacity to apply such a depth of knowledge to such a breadth of situations in a consistent manner. We are still only human ourselves, after all.

Managing Through Complexity With Checklists

So what’s the best way to manage through such an incredible depth of complexity? Gawande notes that the World Health Organization’s classification of diseases now categorizes more than 13,000 ailments, and one study of 41,000 trauma patients in Pennsylvania found that doctors had to contend with 1,224 different injury-related diagnoses in 32,261 unique combinations. To say the least, the difficulty of providing 32,261 different diagnoses in 32,261 different situations is a challenge of enormous complexity for the human brain. So what’s the solution? Checklists, to at least ensure the big things don’t slip through the cracks.

Initially, Gawande notes that the idea of checklists was soundly rejected in the medical world. Given the complexity of the problems involved, how could a single checklist or a series of them possibly have much of an impact? Yet it turns out that even relatively routine checklists can have a remarkably material effect, for the simple reason that as human beings, we don’t always remember to do every single step in a process the exact same way every time, especially when most of the time it doesn’t really matter. For instance, one early study applying a simple checklist to implant a central line (a catheter placed into a large vein to deliver important medication) to patients: 1) wash hands; 2) clean patient’s skin; 3) put sterile drapes over patient; 4) wear mask, hat, gown, and gloves; and 5) put sterile dressing over insertion site after completion – was found to drop an 11% infection rate down to nearly 0%. It turned out, the doctors were mostly consistent in executing all of the steps, but they occasionally skipped a step for any number of accidental or well-intentioned reasons; nonetheless, being accountable to a simple checklist eliminated virtually all the complications, for what was actually a very simple series of steps. That doesn’t mean patients didn’t still have complex health problems, difficult diagnoses, and adverse outcomes; nonetheless, over a two year span, the initial study estimated that in one hospital alone, the checklist had prevented 43 infections, 8 deaths, and saved $2 million dollars!

And notably, the application of checklists is already widespread in other professional contexts. They are a staple of the airline industry, ensuring that even well-trained pilots never miss a single step in the proper execution of flying the plane; notably, such checklists include important guidance about how to quickly handle a wide range of emergency situations where, even if the pilots are trained, it may be difficult to recall, unassisted, the exact proper steps to execute in the heat of a high-stress moment with adrenaline rushing. Similarly, the construction industry also relies heavily on checklists to ensure that buildings are made properly, and that crucial steps aren’t missed that could result in an utter catastrophe. In addition, Gawande points out that an important ancillary benefit of using checklists in such situations is that, when the checklist requires duties of multiple individuals – and everyone is held accountable to ensure all steps of the checklist are completed – teams end out communicating better, which prevents even more unfavorable outcomes.

Creating Your Financial Planning Checklists

Granted, in the financial planning world, the client situations that present themselves are rarely as dire as landing a plane in an emergency or determining what drugs to administer to a patient who may die in minutes or hours if not properly treated. Nonetheless, the fundamental problem remains: financial planning for individuals with a nearly infinite range of situations entails tremendous complexity, to the point where it’s not clear if anyone could really remember every possible question to ask or step to take; at least, not without the assistance of a financial planning checklist.

One version of a quasi-checklist that financial planners already use is the data gathering form, which through its wide range of blanks to fill in amongst various categories, ensures a fairly thorough review of all the client’s potential financial concerns. If you don’t think checklists can be useful, imagine how effective your financial planning process would be if you had to remember, off the top of your head, to ask every question necessary to capture every single bit of information that’s requested on a thorough data-gathering form. Even those who begin using an agenda to guide client meetings often report they help – as a form of checklist – to ensure that all the key issues are covered in the meeting, and that nothing is overlooked in the midst of a potentially complex client conversation.

Similarly, many technical areas in financial planning require not only specialized knowledge, but an awareness of rare-but-potential circumstances that may arise that provide for unique planning opportunities. For instance, with respect to Social Security alone, how often do you ask an unmarried client over the age of 62 if he/she had a former marriage that lasted at least 10 years (potential divorced spouse benefits), or ask retirees over age 62 if there are they still have any children under the age of 18 (extra retirement benefits for children), or ask if the client had a prior (or current) job where he/she did not participate in the Social Security system (future retirement benefits potentially reduced under the Windfall Elimination Provision). While none of these situations are necessarily common, they do occur from time to time – frequent enough to matter, but not frequent enough to necessarily remember to ask every time. The same is true in a wide range of other planning situations, from whether the beneficiary of an inherited IRA might be eligible for an Income In Respect Of A Decent deduction, to whether a non-qualified annuity was originally funded via a 1035 exchange (which means the cost basis is not merely the premiums paid), to whether a term insurance policy is still convertible (or ever was).

In other words, having a financial planning checklist in each of the various areas of financial planning can serve as a type of “due diligence” process, to ensure that all the important planning issues and opportunities are covered. It doesn’t make the planner smarter or more skilled, but does help to ensure that the planner maximizes the knowledge and skill he/she already has. Arguably, at some point in the future, these might even be codified into a more extensive series of Practice Standards for financial planners – as in the case of doctors, this can ultimately help to distinguish between situations where an unfavorable outcome was due to an error or “ineptitude” mistake of the planner, or was simply a situation too complex to possibly be saved. In practice, effective due diligence checklists might also be integrated into a firm’s CRM software.

Atul Gawande Checklist Manifesto

Unfortunately, though, the greatest challenge is simply that we need to build our financial planning checklists – a challenging and time-intensive process. Yet perhaps this is an opportunity for the financial planning community to band together and build something collectively. Have you built any checklists in your firm that you would be willing to share? Would you volunteer time and effort to try to help create a series of financial planning checklists for all practitioners to use? Please respond in the comments if you’re interested, and perhaps we can begin this process together. In the meantime, though, it would probably be a good idea to start building some checklists for the most common challenges that arise in your own financial planning firm!

And if you’re still not convinced of the value of a financial planning checklist (or having a series of them!), I’d strongly encourage you to read “Checklist Manifesto” yourself; if you are convinced, you may also find the book provides helpful inspiration on the kinds of checklists that may be useful in your practice and with your clients.