Consumers face very different challenges today in planning for lifetime financial security from what previous generations did. One might think that different challenges would lead to different solutions. Yet, the wealth management industry today is still referencing an outdated theoretical model, and so, not surprisingly, it is proposing outdated strategies and solutions.

There is, however, a well-developed body of knowledge that addresses the challenges faced by consumers today, and we are beginning to see practical applications of this theory. This shift in theoretical framework explains why our industry has so far not been able to develop an effective single voice to consumers about how best to prepare for lifetime financial security. Wealth managers conversant with the new point of view will be well positioned to act more effectively for their clients and to help shape the emerging new model for wealth management.

Specifically, the wealth management paradigm is transitioning from the Markowitz mean–variance perspective to the life-cycle theory of saving and investing worldview. This shift is as big, exciting, and challenging as when Markowitz’s work forced investment professionals to recognize the importance of investment diversification. Wealth managers today are entering a similar situation in which they will need to choose whether to lead, follow, or get out of the way.

Following is the background and some of the implications for wealth management practices.

Consumers today come to our offices knowing that aside from what they create for themselves, there are few, if any, financial safety nets available to them in old age. The defined-benefit pension plan is dying, and Social Security is uncertain. Longevity and health care costs are increasing. Family support is not as available as in prior generations, and arguably, there are also unrealistic expectations about appropriate savings rates and expected investment returns.

To these challenges, our industry by and large responds with the old paradigm view outlined in Exhibit 1.¹

Exhibit 1                Paradigms of Life-Cycle Finance

The result is that the consumer’s central concern about how to maintain his or her standard of living into old age is not addressed; the risks of longevity, inflation, and principal loss remain on the consumer. In a Wealth Management 101 exam, our industry would—or should—get an F; we have not proposed a solution that meets the client’s needs.

A second reason a low grade would be appropriate is that by our suggested solutions, we indicate that we have let a false assumption creep into the heart of the analysis. Much of our solution rests on the idea that time somehow softens the risk of stock investing, which is simply not true, despite the unrelenting drumbeat of that message in our culture today. Although it is true that the expected average return for stocks converges to a positive number, the range of possible outcomes widens with time. This means that shortfall risk, which is of central concern to individual consumers, actually grows with time. The easy proof is that if you go to Wall Street to purchase insurance (e.g., that the family’s college savings will not be below a certain stated amount on the day tuition is due, the premium increases with time.²

Subsequent to the seminal work of Merton and Samuelson, the Life Cycle Theory of Savings & Investing superseded the Markowitz mean variance model in the 1970s.³  Subsequent academic research has continued to extend the life-cycle model by fully incorporating consideration of labor income choices.⁴ The result is a useful theoretical framework for optimizing lifetime consumption (a.k.a. retirement planning).

Interestingly, the life-cycle theory of savings and investing is a standard part of introductory finance courses, for example, those that might be taken by a typical MBA student. It is also just now being introduced into the CFA curriculum, suggesting that the life-cycle point of view will be the norm for the next generation of wealth managers.

The Life Cycle Theory of Savings & Investing has two core ideas:⁵

1. Consumers have both human capital and financial capital, and financial capital needs to be tailored to human capital
2. Consumers care more about lifetime consumption than wealth

Human capital is the present value of one’s future labor income. It is normally the largest single asset in the early part of the working life of most people, and it declines in relative importance as people age and accumulate other assets.

Like the turn of a kaleidoscope, these two straightforward statements change everything. The first statement shifts the unit of analysis from the portfolio to the consumer. Consideration goes first to what is going on with human capital, and then financial capital is tailored so that the chosen targeted level for overall risk is met.

The second statement brings the importance of financial safety, defined as securing adequate lifetime inflation-protected income, back to the forefront of planning. Inflation-indexed annuities become the norm for at least the base layer of wealth. Retirement planning shifts to gradual, partial annuitization, bundled with long-term care insurance and perhaps some longevity insurance, and with stock investments then layered on top, but only with careful tailoring to the client’s downside risk preference. Bequest interests are addressed with surplus portfolio wealth and/or life insurance.

We also see here that taken as a shorthand expression of a rigorous planning idea, the notion of time horizon as having something to do with investment risk can make a bit more sense. The rigorous, correct statement would be that, rationally, you can consider increased investment risk to the extent you have resiliency in your labor income. Thus, a young professional at the beginning of her career, everything else being equal, can consider ramping up investment risk not because she has a long time horizon but because she has resiliency in her labor income.

In contrast, consider the situation of someone who is 60 years old. Given current longevity trends, he has a long time horizon and so, according to current popular lore, might consider investing heavily in stocks. But if he is not able, either by preference or personal skills, to ramp up lifetime labor income by working longer or harder, then he cannot really afford to take considerable investment risk. Similarly, in the life-cycle worldview, stock brokers, whose income is highly correlated with the stock market, would default to a financial portfolio of very stable investments.

The economist’s theoretical point of view is now becoming a reality. Consumers have access to inflation-indexed annuities for their IRA accounts through a new distribution channel that offers meaningful competition: real-time, apples-to-apples quotes from several top insurance companies. This development may be as big in our industry as the shift from loaded to no-load mutual funds or from the commissioned broker to the fee-only planner model.

Plus, wealth managers are working with Wall Street firms to custom tailor investment products that offer downside protection in exchange for muffled upside exposure. Meanwhile, pension policy experts are proposing that for employer-sponsored pension plans, the default withdrawal should be an annuity of some kind. Financial planners are bringing career advising to the heart of their practice, coordinating with career counselors as routinely as with the client’s attorney, accountant, and insurance agent.

The implications of this paradigm shift for private wealth mangers are far reaching and include the following:

• Arranging inflation-protected lifelong income instead of maximizing portfolio return becomes the central planning issue.
• The fallacy that time softens the risk of stock investing is seen as a mangled version of a more rigorously correct statement.
• Much work needs to be done to bring our clients and the public up to date on the consequent changing norms for best practices.
• New products will begin to cascade into the marketplace. The shift in theoretical model will facilitate accurate evaluation of new products. Target date, or so-called life-cycle funds, that keep investment risk squarely on the consumer will seem outmoded and oddly incorrect.⁶
• Tax rules for retirement plan mandatory withdrawals and eligible IRA assets will need updating, as will prudent investor legal standards for fiduciaries.
• Career asset management will blossom into a standard subspecialty field.
• Best practices will include gradual partial annuitization with inflation-indexed annuities, perhaps bundled with long-term care insurance and/or longevity insurance, along with complementing equity exposure with bounded risk and return features.⁷
• Consumers will gravitate toward insurance-based investment products and will exert increasing pressure for transparent pricing offered through competitive distribution channels.

Practice models, especially those based on fees calculated as a percentage of assets under management will need updating.
Most of these planning implications cross several disciplines and so are best addressed through interdisciplinary conversation, for example, as modeled in the biennial Future of Life Cycle Savings & Investing conference. Savvy wealth managers will need to get up to speed and join the conversation.