How Are You Unconsciously Directing Your Clients? - Financial Planning

Image via Wikipedia Financial Planning magazine

By Pamela J. Black
October 12, 2010

Dan Ariely, author of “Predictably Irrational,” kicked off the festivities at the FPA Annual Conference in Denver with a keynote speech about how people frequently make mistakes because we rely on input from our senses that often give us biased information. This process is totally unconscious.

The Duke University professor of behavioral economics gave many examples of how we do this. One was a chart showing what percentage of people in different European countries who were willing to donate their organs….
What was the difference between the low percentage countries and the high? The enrollment forms.

Cover via AmazonThe former were presented with a form that asked them to check a box if they wanted to be an organ donor, the latter were presented with a form that said check the box if you don’t want to be an organ donor. The fact was that no one checked any of the boxes because when confronted with such an important choice most people don’t know what they think and don’t make a decision. The information box was an environment in which doing nothing led to a decision by default.

Ariely called such environments or contexts “choice architecture,” and said it’s hard to see how much people are influenced by them. “Defaults influence behavior when decisions are hard,” he said, “People don’t know their biases very well, so they follow the form.”
The number of choices a person is faced with also will unconsciously drive behavior. Ariely cites an experiment in California, where psychologists tested consumers at a market with a free jam tasting. One day there were six jams to choose from; another,  there were 24. All  the consumers were given a discount coupon to buy jam. While 30% of the those who saw six jams used it, only one or two who saw 24 jams did. “Twenty-four jams seemed too complex,” he said.
This is not unlike getting people to save in a 401(k) plan. You could offer people an opt-in to the plan, send them a letter saying this was the most important decision of their lives and offer lots of investment choices; or you could offer a target-date fund invested in stocks and bonds that rebalances regularly and an opt-out. The former would tend to drive them away from savings while the latter would encourage them.
He showed also that to the extent people don’t know their preferences, you can change their attitudes based entirely on the context. For example, you can ask one client how he felt on the days when his portfolio lost 5% of its value. He would think about this and get kind of depressed. You could talk to another client about retiring in the Bahamas and they would feel in a good mood. If you then ask them what their attitude toward risk is, the first person will be more conservative and perhaps go for an all-bond portfolio, which may not be in his long-term interests, while the person imagining themselves in the Bahamas is more optimistic and willing to take on more risk. “The question ‘What is your risk attitude is incredibly hard to answer and therefore they will be influenced by things in the background.”
Yet another example of how people are unconsciously biased is comparative analysis.
For example, the Economist magazine had a subscription offer of the Economist.com for $59, the print edition only for $112 and the print and online editions for $125. Twenty percent chose the first option, no one chose the second and 80% chose the third, but when you take out the print only option, the numbers reverse; 64% chose the Economist.com and 32% chose the combination. Once you take out the option by which they framed the combination decision—the two subscriptions are better than just one— it became a less popular option. People may not know what they want, Ariely said, but they do know the combination option is better than the single option.
Ariely gave many other examples of how context determines human behavior. One critical example was about the pain of spending money. There is pain involved in paying for things and you can help take that away where it makes sense or not. Someone who pays for a trip in advance enjoys the experience more than someone who gets the tab on the last day of the trip even though the cost is the same. Likewise, if given a choice between getting $1000 extra a month and a $12,000 bonus at the end of the year, who will enjoy the money more? The one with the bonus because the money won’t get eaten up in everyday living even though it’s the exact same amount. …
His ultimate message: question your own biases because they may well be wrong.
“You have to question your assumptions based on intuition and experiment with trying something different and seeing if another way might not be much better,” he said.

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Advisors Press Business-Owner Clients To Update Valuations

Financial Advisor Magazine

(Dow Jones) The weak economy has dragged down the value of many small businesses and made getting an updated appraisal a discouraging task.
But some financial advisors are pressing business-owning clients to get one anyway, because up-to-date valuations are needed to adjust their retirement and estate plans accordingly. …

Many business owners are so focused on growing the business––or maybe just surviving––that they haven't thought about what has happened to its value. Some businesses are worth 30% less than a few years ago, says Denver financial advisor Dave Seems, who encourages clients to get the appraisal. "It's sort of a wake-up call," he says.

A relatively precise value is needed to make planning decisions, such as whether an owner needs to be saving more outside the business, or whether it is a good time to pass a stake in the business to heirs.

When owners find out their company is worth less than they believe, many make a decision to delay retirement or a sale in the short term. Some are prompted to put more effort into building up business, "to be able to sell at some future point," Seems says.
Kurt DeLucero, owner of Arrowhead Landscape Services in Colorado, wasn't too surprised by the numbers in his company's recent valuation, but he says that the information is useful because it highlights what needs to be done if he wants to be able to sell the business in 10 years.
"I truly like to know [the value]," he says. "It shows me where we are doing well, and where we can make some improvements." …
An owner typically has 50% to 70% of their net worth in their business, says Steven Faulkner, head of specialty assets, J.P. Morgan Private Bank. Often, their investments outside of the business are largely cash, Faulkner says, and he encourages them to have a more diversified portfolio.
Owners often have buy-sell agreements with partners in case one dies, and if such a pact values the business too highly, it can leave survivors with too high a bill to pay. That could even wind up requiring the whole business to be sold.

One silver lining to a lower valuation is the impact on taxes, particularly when passing a business on to heirs. Estate taxes are expected to rise next year and new restrictions on use of trusts could also be coming soon. "Because values are so low and interest rates are so low, there's never been a better time to move assets to the next generation," says Steve Parrish, national advanced solutions consultant for the Principal Financial Group.

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Tax Break Promotes Big Gifts To Grandchildren

Financial Advisor Magazine

Dow Jones) While this year's one-year lapse in the estate tax hogs the spotlight, a lesser-known gap is offering many affluent older people a tax-free way to pass on some of their wealth to grandchildren.

Gifts have to meet certain conditions to get a break on the generation-skipping transfer tax, or GST, which also has been repealed for 2010. Only outright gifts qualify as opposed to, say, putting money in a trust, but the definition of a gift is broad enough: Someone who sets up a partnership and gives away units in it can get the tax break, for example.

David Pratt, managing partner of the personal planning department of the Boca Raton, Fla., office of law firm Proskauer Rose, says his firm is doing a lot of planning for gifts to grandchildren using family limited partnerships. The idea of putting a gift into a vehicle like this is to keep a youngster from getting control over assets all at once and possibly squandering them.

The generation-skipping tax is separate from income, estate and gift taxes. Its purpose is to keep people from transferring property too many generations out without paying tax. The tax is imposed if the transfer avoids gift or estate tax.

Take the example of a man who dies with a multi-million dollar estate, leaving his property in a trust with income payable to his children. On his death, trust assets are to go to the grandchildren. The man's estate would owe estate tax, but on the death of his children, the trust property would not be taxable in their name, so the family would have skipped a generation of estate tax. Therefore, the generation-skipping tax would apply.

The tax applies not just to grandchildren but to all so-called "skip" persons, including unrelated heirs at least 37-and-a-half years younger than a donor.

This year's donors still must pay the gift tax, at a top rate of 35%. That is the lowest level since 1934. The lifetime exemption this year on the gift tax is $1 million. Next year, unless Congress acts, the gift tax will rise to 55%, where it was before the Bush tax cuts of 2001 started taking effect.

Each donor is allowed to exempt up to a certain amount in generation-skipping gifts. Last year it was $3.5 million, and next year will be in the neighborhood of $1.06 million. (The government has not yet confirmed the new amount for 2011.) So, a donor will not owe generation-skipping tax on the first $1.06 million or so in 2011, but will owe the gift tax and the GST on any amount over that.

J.P. Morgan, in a recent analysis on taxable gifts, found that the net benefit to a recipient from a $1 million gift made in 2010, as compared to 2011, would be $305,565. That benefit grows proportionally to the assets' growth.

Making a taxable gift to a grandchild or other skip person, even in 2011, is still a smarter tax move than simply leaving the same amount to the person through the estate, according to J.P. Morgan. For every $100 of a gift in 2010, the grandchild gets $74, as compared to $42 in 2011. …

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A better way to anticipate downturns

Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.

McKinsey Quarterly
OCTOBER 2010 • Tim Koller
Source: Corporate Finance Practice



What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic.¹ And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.
They shouldn’t. The fact is that those markets, … don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and real economies, the credit markets can provide clearer indicators that a recession is on the horizon.

Collective wisdom falls short

Subscribers to the theory that markets process all information efficiently would argue that equity investors should be in very good shape to recognize early indications of a looming downturn. If that were indeed the case, current market valuations might inspire confidence. … And since equity markets do a reasonably good job of tracking long-term economic fundamentals,² investors can expect longer-term returns—dividends and share price appreciation—that are in line with historical real returns, in the range of 6 to 7 percent.
Of course, the fact that the stock market is currently in line with the long-term trend doesn’t rule out the possibility of major fluctuations on the way to the longer term. The performance of equity markets shows that they have not been a good predictor of past recessions. Indeed, during every major recession since the early 1970s, most of the decline in the S&P 500 index occurred after the economy had already slowed (Exhibit 1). … Our analysis suggests that the equity markets give too much weight to current economic activity rather than to the situation likely to materialize in a couple of months or even a year.

Exhibit 1: Most of the decline in equity markets comes after a recession has already begun.

Moreover, when the index’s value does drop during nonrecessionary periods, this rarely signals a coming downturn. In the past 30 years, there have been few major declines in the market outside of recessions (Exhibit 2). Even an extreme case, such as the 20 percent drop during a couple of days in 1987, didn’t portend a systemic downturn, and the index was back to normal a mere two months later. In the past, such market fluctuations have been caused mostly by forces that didn’t have anything to do with the real economy—and any effect they had dissipated very quickly. Equity markets played the more typical role of bystander, buffeted by and reacting to economic events rather than anticipating them.

Exhibit 2: Stock market declines do not indicate economic downturns.

While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times. … During that time, the S&P 500’s long-term trend value—the value you would expect to see if you were confident that the economy would recover to its long-term trend within several years—stood at about 1,100–1,300. Therefore, no one should have been surprised to see a drop to the 900–1,000 level, given uncertainty about the depth and duration of the recession. …

Incubators of crisis

Unlike equity markets, credit markets don’t always function smoothly during difficult times. That, in part, is why they are a better source of clues about where the economy is heading. The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past 30 to 40 years (Exhibit 3). Such crises include not only the recent property debacle in the United States and the 1990 one in Japan but also the crises generated by excessive government borrowing in Latin America in 1980 and by excessive corporate borrowing in Southeast Asia in 1997. So executives who find reasons for optimism in today’s equity market levels might be less sanguine looking at today’s credit markets. It’s still not clear whether prices have stabilized in once overheated real-estate markets. Banks are still somewhat vulnerable. And the level of government debt in the United States and elsewhere is still an issue.

Exhibit 3: Most major downturns in the past 30 to 40 years have been driven by some sort of credit crisis.

Moreover, the pattern of crisis development shows clearly enough that the one thing we can know for certain is that economic crises will erupt in the future—in part because the credit markets work almost as if designed to cause them. That may be a provocative point, but consider this:

• The credit markets are extremely illiquid. The trading volume of most equities is many orders of magnitude greater than that of typical debt instruments. … This illiquidity sometimes makes it difficult for banks or other investors to sell credit assets at a reasonable price. In addition, providers of short-term credit—to banks, hedge funds, and other financial institutions—may be simply unwilling to extend new credit when old debt comes due, forcing debtors to sell assets to pay down debt just as they are least sellable.
• The banking system and many investors, particularly hedge funds, earn a significant portion of their profits on the mismatch between their assets and liabilities: they invest in longer-term loans and other investments and borrow with short-term deposits and debt. … Normally, this formula works well. But two things can happen to disrupt it. Sometimes the yield curve inverts, with short-term interest rates higher than long-term rates; then, normal banking profits disappear. More important, short-term credit markets sometimes freeze up, so banks, hedge funds, or financial institutions can’t get short-term debt at a reasonable price, or any price. As a result, they sell assets at distressed prices—if they can find buyers.
• The system suffers from chronic group-think. … Banks and investors observe which banks or other investors seem to be making the highest profits and then implement similar strategies. If contrarians in the market were to counterbalance credit excesses, the system should stay in equilibrium. But the system makes it very difficult for investors with contrarian views to apply them. …
• Expectations of government bailouts create tremendous moral hazard—… If the European Union hadn’t been expected to step in and rescue the country, the spreads on its debt would have been much higher, years before the crisis hit, relative to, say, German bonds or other euro bonds, given the enormous levels of government debt and its large social obligations. Instead, investors assumed that the EU or one of its members would bail out Greece and continued to lend to it at rates far below levels that would have reflected the true risk of the debt. And in the end they were right, as the EU stepped in.

Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable. The only way to stop one is to anticipate it years in advance; for example, preventing the US subprime crisis would have required clamping down on borrowing in 2005. Avoiding the crisis in Greece would have required something similar in 2005, 2006, or even earlier.

Foreshadowing a downturn

The good news, relatively speaking, for managers of companies is that because the conditions for a crisis are in place several years in advance, it is possible to see the signs of one coming—and to avoid getting caught up in credit market hazards.³

Loose lending standards

One clear sign of trouble ahead is a deterioration of lending criteria. … [During] the 2005 real-estate bubble in the United States, buyers with little or no evidence of their ability to carry a mortgage could purchase houses.

Unusually high leverage

Another warning sign of crisis is unusually high debt levels and mismatches between assets and liabilities, whether by financial institutions, companies, governments, or individuals. For example, in the months leading up to the real-estate crisis that erupted in 2007, the leverage of both banks and consumers in the United States was at unusually high levels. In addition, many consumers were financing their homes—long-term, illiquid assets—with debt in the form of adjustable-rate mortgages that had the characteristics of short-term debt.
In the 1997 Asian crisis, companies financed production facilities—obviously long-term investments—with debt in US dollars. When the dollar strengthened, borrowers needed more local currency cash flows to service the debt. And as hedge funds have grown over the past decade, the importance to their returns of their financing model—short-term debt to finance less liquid assets at very high leverage levels of 90 percent or more—has largely been left unspoken. The general public couldn’t see how leveraged these funds were, but the banks lending to them could. And even with full access to their balance sheets, no single bank was willing to give up the business as long as the hedge funds were profitable customers.

Transactions without value

It isn’t always easy for casual observers to notice, but subtle signs often indicate that financial transactions are proliferating even when they aren’t creating value (for example, by substantially easing the allocation of capital). Indeed, many collateralized debt obligations, such as those blamed for the great credit crisis that resulted in the demise of Lehman Brothers two years ago, fall into this category. … Whenever a company tries to take debt off its balance sheet, investors would be well advised to wonder why. These transactions generate a lot of fees for bankers but rarely create any value.
Watching the equity markets for signs of future crises or downturns is unlikely to provide the kind of advance notice that can inform strategic decisions. Executives with the tenacity to follow the many moving parts of the credit markets are likely to be better prepared when the economy does turn sour.

About the Author

Tim Koller is a principal in McKinsey’s New York office.

Notes

¹ “Economic Conditions Snapshot, September 2010: McKinsey Global Survey results,” mckinseyquarterly.com, September 2010.
² See Richard Dobbs, Bill Huyett, and Tim Koller, Value: The Four Cornerstones of Corporate Finance, Hoboken, NJ: Wiley, November 2010.
³ Indeed, US industrial companies that entered the crisis with healthy balance sheets were able to withstand the crisis reasonably well, precisely because they were not overleveraged and had sufficient cash reserves to be flexible as the crisis wore on.

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Employees Value More Employers that Offer Voluntary Benefits

Image via Wikipedia October 6, 2010 (PLANSPONSOR.com) - According to a survey conducted for insurer WellPoint, Inc., most employees (83%) think more highly of employers that offer voluntary insurance benefits than those that don't.

In addition, nearly 90% of respondents report that when it comes to accepting a new job, it is important that companies offer a full range of health benefits, including voluntary. More than half (56%) said it is "very important." 

Image via Wikipedia

According to a press release, eight in ten employees whose company offers voluntary benefits (82%) are satisfied with their benefits offerings, compared to 30% of those whose companies do not offer such benefits.

The top reasons employees cited for enrolling in voluntary benefits include cost savings (54%), greater protection for their families (50%), and ease of mind (44%).

Additional survey results include:

• Two thirds of employees (67%) say their company currently offers voluntary insurance.
• Specific groups of employed Americans are more likely to report their company offers voluntary insurance, including men (71%), those located in the Northeast region of the United States (74%), workers at large companies (81%), and those with an average household income of $50,000 or more (74%).
• Only half of workers (56%) say they are knowledgeable about the voluntary insurance products offered at their companies.
• The majority of workers agree (67%) that having their employer provide voluntary benefits would increase their productivity at work.

The survey was conducted online among a national sample of 2,500 Americans ages 18+ in August 2010.

Rebecca Moore
editors@plansponsor.com