Two leading researchers on human capital, tailoring the right asset allocation, and more.
Our guests this week are Tom Idzorek and Paul Kaplan. This is Tom’s second appearance as a guest and Paul’s first. Tom is chief investment officer of retirement for Morningstar Investment Management. He also serves as a member of Morningstar’s 401(k) Committee, Public Policy Council, Global Investment Committee, US Investment Policy Committee, and the Editorial Board of Morningstar Magazine. Before retiring in 2023, Paul was director of research for Morningstar Canada and a senior member of Morningstar’s Global Research Team. He led the development of many of the quantitative methodologies behind Morningstar’s fund analysis, indexes, advisor tools, and other services. Tom and Paul are accomplished researchers and authors, having individually published or collaborated on numerous academic papers, accepted to prestigious peer-reviewed journals, and their work has received numerous awards through the years. In today’s interview, we’re focusing on one of their recent collaborations, their new book, Lifetime Financial Advice: A Personalized Optimal Multilevel Approach.
Background
“Tom Idzorek: Exploring the Role of Human and Financial Capital in Retirement Planning,” The Long View podcast, Morningstar.com, June 7, 2022.
Lifetime Financial Advice: A Personalized Optimal Multilevel Approach, by Tom Idzorek and Paul Kaplan
Lifetime Financial Advice
“Joining Lifecycle Models With Mean-Variance Optimization,” by Tom Idzorek and Paul Kaplan, papers.ssrn.com, Oct. 19, 2023.
Lifetime Financial Advice Book Club Series
“Personalized Multiple Account Portfolio Optimization,” by Tom Idzorek, Financial Analysts Journal, June 29, 2023.
“The Popularity Asset Pricing Model,” by Tom Idzorek, Paul Kaplan, and Roger Ibbotson, papers.ssrn.com, Oct. 26, 2021.
“Popularity: A Bridge Between Classical and Behavioral Finance,” by Roger Ibbotson, Tom Idzorek, Paul Kaplan, and James Xiong, Research Foundation, Dec. 10, 2018.
“ESG Investing and the Popularity Asset Pricing Model (PAPM),” by Tom Idzorek, blogs.cfainstitute.org, Feb. 1, 2024.
Other
“Modern Portfolio Theory: What MPT Is and How Investors Use It,” by the Investopedia team, Investopedia.com, Aug. 29, 2023.
Jeff Ptak: Hi and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guests this week are Tom Idzorek and Paul Kaplan. This is Tom’s second appearance as a guest and Paul’s first. Tom is chief investment officer of retirement for Morningstar Investment Management. He also serves as a member of Morningstar’s 401(k) Committee, Public Policy Council, Global Investment Committee, US Investment Policy Committee, and the Editorial Board of Morningstar Magazine. Before retiring in 2023, Paul was director of research for Morningstar Canada and a senior member of Morningstar’s Global Research Team. He led the development of many of the quantitative methodologies behind Morningstar’s fund analysis, indexes, advisor tools, and other services. Tom and Paul are accomplished researchers and authors, having individually published or collaborated on numerous academic papers, accepted to prestigious peer-reviewed journals, and their work has received numerous awards through the years. In today’s interview, we’re focusing on one of their recent collaborations, their new book, Lifetime Financial Advice: A Personalized Optimal Multilevel Approach.
Tom and Paul, welcome to The Long View.
Tom Idzorek: Thanks for having us.
Paul Kaplan: Yes, thank you for having us.
Ptak: It’s our pleasure. Thanks again for being here. We’re really excited to have this conversation. So I wanted to start, we’re going to talk quite a bit about the book, but we wanted to start by situating it, putting it into context. So maybe Tom, I’ll start with you. Before we dive into the details of the book, can you talk about how the research that figured into the book, how that fits into your day-to-day work, and also where might a user of Morningstar products or services encounter the research that underpins the book?
Idzorek: Sure. I’ll attempt that. I work within the Morningstar Retirement Group. Its primary offering is this type of discretionary, robolike advice service that employees, people with a retirement plan, access through their employer-sponsored retirement plan. In contrast to maybe the retail robos, which I think of as being say, investment-centric, this type of system, in my opinion, is financial-planning-light, coupled with personalized, ongoing portfolio management. And, the book, I guess, is, in my mind, a blueprint related to maybe a similar service that I might think of as an advisor empowerment tool. And in the book, as an example, we start off with a 25-year-old hypothetical investor Isabella, who’s working with her planner, Paula the Planner. And in the book, Paula is using a hypothetical system based on the book to deliver ongoing financial planning with investment management to her client Isabella, and we follow her throughout her life. And so, again, within my work at Morningstar, we’re developing these types of capabilities, and I’m hopeful that we’ll develop further tools that would be available to not just those that have, say, a retirement plan that is using Morningstar to power some of the services, but also to provide this to a wider group of advisors.
Benz: Sticking with you, Tom, many of our listeners are individual investors or financial advisors. To tee up this conversation for them, what’s your pitch for why they should pay attention to the types of topics that you cover in the book?
Idzorek: Well, I’m bad at a pitch. I guess I’m not convinced that the topics that we cover in this book, I think they’re certainly important to ultimately to individual investors and to advisors. But I would say, if we’re being honest, I don’t want to lose your audience. I guess the book is really designed toward a sophisticated audience. I would think about, the types of people that are perhaps pursuing maybe a PhD in financial planning, the types of people that work at the home office that oversees maybe a network of financial advisors and planners. So it’s geared toward a sophisticated audience. And I guess in terms of maybe why it’s important, again, I think it’s, again, I hate to say this because it’s about our own work, but I feel like what we’re doing is groundbreaking work in terms of advancing financial planning as we know it—designing, and I think we’ll get into this, a new type of model that’s related to the work of a number of Nobel Prize winners. And I guess I’m hopeful that this type of model will become mainstream in terms of its use throughout the industry, changing financial planning as we know it. So I guess anything that’s going to change financial planning, I hope will be of interest to a wide audience of people.
Ptak: So let’s talk about lifetime financial advice, it’s in the title of the book. Paul, for this one, I thought we would turn to you. Maybe you can talk at a high level. Explain what lifetime financial advice is and also how it differs from traditional approaches to delivering financial advice.
Kaplan: Yes, so we’re calling lifetime financial advice is rooted in a body of economic literature called lifecycle finance. And lifecycle finance has been developed by a number of Nobel Prize-winning economists. And there’s actually quite a number of Nobel laureates that have contributed to the field. But I’ll just mention briefly four very important contributors. One was Milton Friedman, another was Franco Modigliani, Paul Samuelson, and Robert Merton. And Friedman and Modigliani, when the Nobel Prize committee announced that they were the laureates, they did mention their work in lifecycle finance. Samuelson and Merton developed their work a bit later after the work that they had done, they got the prize in. So why is this important? Because economics is a way of developing, it’s really a set of tools that is both holistic and rational. And how does that differ from traditional financial-planning approaches?
Well, holistic, so in traditional approaches, you might have one rule that says how much you should spend each year and another rule that says how you should do your asset allocation in your portfolio. Those two might come from different places. And how do you know that the rules that you’ve chosen for those two issues actually work together? Secondly, it’s rational. This is the rational approach. Of course, as we know from the work done by a number of behavioral economists, including Richard Thaler and Danny Kahneman, Nobel Prize laureates, that people are left to their own devices will not behave in a rational way. And to us, this means that the role of the financial planner is all the more important because that means the financial planner can take on a role of being a behavioral coach and help the clients make rational, holistic decisions. But to do that, they need a set of tools that are rational and holistic. And that’s what our book really addresses, what such an approach looks like.
Benz: Tom, maybe you can expand on what Paul just said. Why do you see lifecycle finance as critical for personal financial planning?
Idzorek: I guess I’m going to say joy or perhaps, happiness or satisfaction. And so, the models that Paul is talking about involve complicated, interdependent trade-offs that one has to make throughout their lives. And, at the heart of a lifecycle finance model is the idea that that investor is trying to maximize lifetime expected utility. And again, where utility is this word that is indicating, joy, happiness, satisfaction. And, as Paul was saying, to me, this is the scientific method of making those complicated trade-offs in pursuit of really the highest or maximum expected level of lifetime utility. And so, if one were to maybe follow the traditional approach, I think they’re just leaving something on the table. Traditional financial planning is going to help investors and it’s definitely an improvement over not planning at all. But let’s say you had a person and they’re so-so on maybe oatmeal cookies, but they really enjoy chocolate chip cookies. They either are happy enough eating oatmeal cookies, but if they had had chocolate chip cookies, they would have been much happier. And by using this scientific type of planning, lifecycle finance, planning based on lifecycle finance, what you’re really trying to do is make sure that you’re not leaving something on the table and that you’re maximizing the satisfaction or utility or joy that somebody has an association with all these complicated decisions that they must make throughout their lifetime.
Ptak: I wanted to talk about human capital and liabilities is a concept that’s very much central to the overall framework that you present in the book. Paul, for this one, I’ll turn to you. I wondered how does the inclusion of human capital and liabilities into, what you might call an economic balance sheet? How does that enhance traditional financial planning?
Kaplan: Well, what it does is it gives a complete picture of the financial situation of the investor. I think if you probably asked most people to draw a balance sheet, they would put in their mutual funds and their brokerage accounts and all that sort of thing on one side, and the other side, they put like their mortgage or other liabilities that they have. And that’s a very incomplete picture from an economic point of view because the investor is more than just those financial assets and liabilities. Human capital is a recognition that one of the most important assets that each of us has is the fact that we have a stream of income, coming ahead of us from now and to the rest of our lives. And of course, when we’re working that yes, mainly our salary, but even after we retire, we might have some kind of social insurance such as Social Security in the US or the Canadian Pension Plan here in Canada. And that we also need to count as income. And what do we do in economics? How do we look at a stream of future income and boil it down to one number is we fake the present discounted value. So that’s what we do.
Now, obviously there’s a question about what discount rate you should use, and we addressed it in the book, but that’s the idea. Similarly, on the liability side, if we can look at all let’s say our nondiscretionary consumption, we all need food, we all need clothing, we all need shelter, we have to pay for these things. And so in our approach, we take the present discounted value of that spending, and we call that the liability. And so when we draw the economic balance sheet on the asset side of the sheet, is financial assets and human capital and then on the righthand side, we have the liabilities and then the difference between the left and the righthand side, which is called net worth. So economic net worth is the best single indicator there is of what is still the financial state of an investor.
Benz: Tom, how do enabling technologies like artificial intelligence change the calculus we might have formerly used to model human capital and does that have implications for how we build financial plans?
Idzorek: Yeah, absolutely. So I guess when discussing AI, I like to differentiate between the latest hot flavor of AI that’s in the news, generative AI, the use of these large language models, versus what I might call an expert systems type of AI. And so in the book, the models that Paul and I are advancing and developing involve simulation, optimization, probabilities, different forecasting mechanisms. And I think of that as perhaps a form of an expert systems AI. And then, so from that perspective, I guess I feel like these traditional expert systems techniques provide us, with a solid foundation for just calculating human capital. Paul was just talking about discounting back at the appropriate discount rate. I guess, where I see perhaps AI influencing, I guess the calculation—it’s not really the calculation of human capital. It’s more the description of it.
So to the degree that we can already calculate that value. It’s perhaps hard to explain what went into that calculation, what is human capital. What might alter somebody’s human capital? I guess that’s where I see what’s going on with generative AI as being a fantastic device for taking a complicated subject and doing a better, in fact, they’d probably do a better job of explaining than I’m doing right now. And so it’s more probably on how do you communicate to individual investors and advisors the concept of human capital, what is changing its value, how its value changes over time, and then what are the implications of human capital for how you should be investing the rest of your assets.
Ptak: Paul, one of the concepts you discuss in the book, and it’s a concept that’s mentioned in the title of the book is what you call the personalized, optimal, multilevel approach. What is it and how does it fit into lifetime financial advice?
Kaplan: Yeah, well, the first word personalized refers to the fact that in a lifecycle model, there is this personal information that’s going into it. And I categorize that into three groups. So one is preferences. Every investor has preferences regarding how much they prefer to have consumption now versus consumption later. There is risk tolerance, how much risk are you willing to take in your overall net worth. And then there are some preferences regarding bequest. How important is it to you to leave a bequest? So those are the preferences. And those preferences are really going to drive a lot of what our approach is going to get to in terms of all the decisions regarding consumption and asset allocation and how much life insurance to buy and the use of annuity. Everything’s going to be tied back to preferences.
The second one, needs. Needs are what I was mentioning earlier about liabilities. So over time, we all have needs. Those can potentially vary over time. And so we want to take that into account as well, before our liabilities. And finally, there’s our circumstances. How much financial wealth do we have? Where am I in the lifecycle? Am I 25 and just starting out on my career? Am I older? Am I retired? These are the things that are going to impact your human capital. And so all that goes in. So, preferences, needs, and circumstances all go into the calculations to create a rational holistic plan of how much to consume or spend and how to invest your assets.
Benz: Tom, can you explain the main components of the three-level parent, child, grandchild model and why you think that framework improves on previous models?
Idzorek: The book is organized, essentially into three parts that follow that structure of a parent, child, and grandchild model. So, at the highest level, we have our parent model, which is the model that is most closely based on lifecycle finance. And in my mind, it answers those big- picture questions that we’ve mentioned. So, how much to consume, how much to save, what should be the appropriate risk level, let’s say for your financial assets in light of other things like your human capital that Paul was just talking about. Do you need life insurance and how much do you need guaranteed income? If so, how much? So that’s really the parent model. And this big-picture picture of that individual economic balance sheet that Paul was talking about, those inputs are coming, those are outputs coming from that lifecycle model that feed into the child model, where we call our child model, net worth optimization.
And net-worth optimization is really an extension of another Nobel Prize winner, Harry Markowitz’s mean-variance optimization approach, but rather than just optimizing, say one’s financial assets, in light of that person’s balance sheet, which includes their financial capital, their human capital as assets, and their liability, we’re optimizing that entire system. And so that child model produces target asset allocations for an individual for their taxable, tax-deferred, and tax-exempt accounts. And those targets then feed into our grandchild model, the final model, which is where the rubber meets the road. And in that grandchild model, which has the form of something referred to as an alpha tracking-error optimization.
What we’ve done there is we’ve built a model that can simultaneously look across an investor’s different set of accounts and adjusts or incorporates the idea that there might be different tax types. And then in light of that information, it can say what should you be buying and selling across all of your different accounts? And it can answer a bunch of other questions too that we think are relatively unique so we can decide whether or not it’s in the best interest of that investor to do a rollover or maybe a reverse rollover or a partial rollover. Within their taxable accounts, it can be doing like a form of holistic tax-loss harvesting. If somebody has new money to deploy, this child model will say here’s the optimal place to deploy that money. For those people that are withdrawing money across their accounts, it can help you decide what actually should you be selling in order to create that maybe retirement-type paycheck. Quite powerful. And then I think the latter part of your question is why is this better? Well, to me, it’s a cohesive framework that is all working together. Again, based on the personal preference of that individual, their unique circumstances to provide a maximum, or I should say utility-maximizing answer for that person.
Ptak: Let’s talk about personalized advice, which is a key theme in the book. Paul, how does the model make the process of personalizing recommendations more effective and efficient overall?
Kaplan: Well, it does that because there is an underlying mathematical model that takes all these inputs into account, such as risk tolerance and preferences regarding when you want consumption, preferences regarding how big a bequest you want to leave. It takes all those into account and those personalized preferences. And, as I also mentioned, the needs, so it estimates the liability. And then also whatever the unique circumstances of the individual, regarding their human capital, all those things are basically going into the same mathematical model. And what’s coming out of the model is an internally consistent, rational, holistic set of recommendations.
Benz: Tom, what does that look like when it comes to the advice given on asset allocation or spending patterns? And perhaps you can talk about how it differs from the advice that someone would get from an off-the-shelf-type solution.
Idzorek: Well, the answer I guess depends on the individual in question. So if you’re Joe Average, maybe the advice coming from this type of model doesn’t really look that different. Of course, I think, most people are unique in terms of their circumstances. And of course, their preferences. And so to the degree that a person does not look like Joe Average, they’re going to have a very different-looking solution. So I guess for Joe Average, it might look very much like that kind of standard or off-the-shelf-type solution. But for a number of people, other people, it can look significantly different and maybe that highlights what I might think it was a weakness of current practices where we often rely on heuristics and sometimes the heuristic is working just fine. And it probably works just fine when you’re a stereotypical person receiving advice, but to the degree that your situation is unique, your preferences are unique. That’s when this type of personalized solution will look quite a bit different.
Ptak: Paul, your model allows for determining optimal consumption levels at each stage of life. How does this work in practice for individuals adjusting the life changes and then related to that, how does the model help people make trade-offs between immediate spending and long-term financial goals?
Kaplan: I think I can address the second question first, and then come back to the first question. Because in the lifecycle finance literature, there’s a term called consumption smoothing. And the idea of consumption smoothing is that when you retire, you really don’t want to move to a completely different spending level than when you were working. And this is the reason why, and, as I think it was generally understood, as you have income coming in, what you do is you convert some of that income into savings and you invest that savings. So, your human capital tends to decline over your lifetime. But as it’s declining preretirement, you are building up more and more financial wealth as well. And then when you retire, you now have financial wealth to live off of. And so you’re basically able to maintain a similar level of consumption as when you before retired. So that’s what’s referred to as consumption smoothing. And for the first question, of course, anytime there’s any change to any of the inputs, the thing to do is to update the inputs to what they are. So, there could be life changes. So, for example, suppose you got an inheritance. Now your financial wealth, all of a sudden, it’s going to jump up. So, that’s going to have effects on your spending and on your investing as time goes on. Or if you were to update your life expectancy, you put that change in life expectancy into the model, and it would make the appropriate changes.
Benz: Tom, what are some aspects of financial planning where perfect shouldn’t be the enemy of the good? And how does your model allow for that?
Idzorek: Probably in all areas. I guess maybe I’ll start off with my perception, just of typical financial planning, as I understand it. And maybe I don’t understand it correctly. But it seems as if there’s usually this relatively large exercise upfront, where somebody is going through the plan, they are gathering information, and eventually the plan is created. And then, again, as I understand it, unless there’s some sort of major change in that person’s life circumstances, what would happen is that they’d come back in a year or so and revisit that plan. I guess in terms of the new type of robo-esque financial planning, light, auto, portfolio management system that, again, I think that the book is presenting is really designed to be perhaps more akin to an auto-rebalancer, but for your financial plan. And so if everything in the book, as we’ve put it out, could come to fruition, as things changed, the plan would simply just update automatically. And therefore, hopefully perfection wouldn’t be the enemy of good here. So Paul just gave some great examples. I guess I’m thinking, perhaps more typically, if the markets went way up or they went way down, or maybe one month, somebody/you just had to spend a lot more than they had anticipated. Again, if done correctly, this would feed into an auto-updating financial plan that could be essentially carried out on behalf of that person without having to come back a year later and say, where have we gone awry, where haven’t we? And it would be a bunch of small rapid-fire, I would say, course corrections as opposed to that annual course correction.
Ptak: Let’s shift and talk taxes. Paul, the paper discusses the role of tax efficiency and asset location. Could you explain how single-period and multi-period optimization—these are concepts that you cover in the book—how those work together for tax-efficient investing?
Kaplan: Yes. So as we’ve mentioned, the book presents a three-level model. So there’s the first model, the parent model, and that’s the lifecycle model. That’s the model that really comes out of the lifecycle literature. And that is a multiperiod optimization because what you’re optimizing is the amount of what economists call utility or I think as Thomas referred to as happiness—what makes you the happiest over the course of your life? What level of consumption do you want, let’s say, each year? Each year you want to do a review and implementation of your asset allocation. So what you want to do is to do an asset allocation both within your taxable assets and your tax-deferred assets or things that are qualified where you’re not going to be paying taxes right away on. And the approach we have there is basically an extension of the model created by Harry Markowitz in which there are two kinds of assets. There’s taxable and let’s call them the ones that have a tax preference. So year in and year out, what you earn on the taxable side, you have to pay taxes on that. And that’s what we’ve done is we’ve incorporated the taxes to come up with an aftertax return on those assets. And then you have the other assets, which you’re not paying an immediate tax on.
And those are going to have a different level of return even if you’re investing in the same asset class. So what we do in this child model is from the parent model, we get all the information about the economic balance sheet and we bake that into this approach that comes up with what your asset allocation should be in taxable versus tax-deferred or tax-exempt assets. So what you might expect to happen in this is in terms of asset location is that you would have your most tax-inefficient assets, you would expect to find those in the let’s say the tax advantage side of things. So that would typically include bonds. And then on the things that are more tax-efficient, like stocks, you would expect to find those on the taxable side. But it doesn’t always necessarily exactly work out that way. It just all depends upon how all these inputs come together.
Benz: Tom, what practical advice would you offer to individual investors or financial advisors seeking to maximize tax efficiency apart from reading your book, that is?
Idzorek: Well, you guys work with me. Practical advice on the fly, that’s not my strength. Can I phone a friend, and can I ask them to call you? I guess I would channel my inner Christine Benz, and I think Paul was kind of answering some of those questions a little bit. But in your taxable accounts, it’d be low-cost passive investments that are hopefully going to be relatively tax-efficient, should be owned in your taxable accounts. And then in general, as Paul probably just said, to the degree that something’s tax inefficient, probably like say your bond funds and your fixed-income funds by and large should be held in qualified accounts.
Ptak: We’ll stick with you, Tom, for a minute and talk about nonfinancial preferences. Some of our listeners perhaps don’t define success in strictly financial terms. How does the model incorporate nonfinancial preferences, which can be stuff like what in the industry is called ESG, for instance?
Idzorek: Sure, a great question. And of course, I think it’s a topic that is near and to our hearts. Stepping back a smidge, Paul and I, along with Roger Ibbotson and James Xiong, also of Morningstar, I feel like we’ve done a lot of work in this world of nonfinancial preferences and how the aggregate preferences of people ultimately influence asset prices and personalized portfolio construction. I think, as you may know, we created a homegrown asset-pricing model that we’d argue improves upon the most ubiquitous asset-pricing model, the capital asset-pricing model, where our model is called the popularity asset-pricing model. And so, but earlier I was discussing, the child model, which is that alpha tracking-error optimization model where we’re deciding what to buy and sell. And so, what’s in somewhat in part two of the book, and mostly in part three of the book, we discuss how one might first of all measure the degree to which somebody has nonpecuniary or nonfinancial preferences. Those could be related to ESG or any other—they could be for religious reasons, other value reasons or, whatever is important to the end investor. And what we’ve done is using the overall framework that we’ve been talking about where trade-offs matter, after one has solicited those preferences, those nonfinancial preferences, how do you actually build a personalized portfolio that reflects the preferences of an individual?
Benz: To stay with you, Tom, do you see increased demand for ESG customization among individual investors? And what advice would you give advisors on this trend?
Idzorek: Customization in general I think it’s something that we’ve all come to expect in maybe all aspects of our lives. And again, whether it’s ESG or otherwise, I think we just all want more and more tailored solutions that meet our needs. And so as a trend, I just think that personalization is only growing. Where only the need that advisors will need to fulfill is how do they meet their clients' needs in a more and more personalized way? So I guess I see the trend is just the need for more customization. In my mind, the advisor world today is filled with the concept of the model portfolio. And the advisor has their model portfolios and they’re trying to use those to manage the money of their book of business.
And I guess in my mind, that was due to technological limitations in the past. It used to be avant-garde to have a model portfolio. I think that we are now at a point in time where, again, using some of the methods described in the book, we can, there are methods for advisors to provide truly personalized portfolios for their entire book of business in a way that is just as easy and scalable from an advisor’s perspective as using a model portfolio. So, again, I guess to me the big trend of personalization is here. ESG has become a bit of a politicized issue here in the United States. But again, big picture, I think that the concepts and ideas behind ESG are very important to the degree that they matter for a given investor. Again, the important thing is the tools are here for an advisor to reflect whatever values a person has in a given portfolio.
Ptak: We’ll shift and talk a little bit about risk management and insurance products. Paul, can you explain the role of insurance products like life insurance and annuities within the lifecycle model?
Kaplan: Yes, and actually, the usefulness of those products arises out of the fact that none of us knows when we’re going to take our last breath. And so, life insurance deals with the side with the mortality problem, which is that, let’s say if we have people who are depending on our income, and, if our lives end early, the problem is that those people that were depending on us won’t have anything anymore. So, what we do is we buy life insurance at that point, and then so if something were to happen to us, there’s something left for those that are depending on us. And annuities deals with the other end of that problem, which is longevity risk. Since we don’t know when we’re going to take our last breath, and there might be a lot of longevity, as we’re seeing, then the problem we could face is that what happens to our financial resources? We don’t want to live beyond our means. So what we do is we could buy annuities to address that problem and create a guaranteed level of income that will last as long as we do.
Benz: So, to follow up, Paul, how do your recommendations around life insurance and annuities change as investors move through different life stages? It sounds like once dependents have left the nest that you would move away from life insurance to more of something that will protect you against living a really long life. Is that how you think about it?
Kaplan: Yes, but also there’s a little bit more to it, which is what type of life insurance should you buy. There’s term life, there’s whole life, and there’s other variations. So, the thing is this, is that while you are working and you are converting your income into financial wealth, that means the given level of bequest, your need for life insurance should be reduced over time. And you may be able to, in fact, have enough money put away that you don’t need life insurance any more at all. And if you’re following that strategy, then what you need is term life insurance, where every year you renew your life insurance policy, but you only renew it to the extent to which you need it. And so the amount of term life insurance you buy each year is going to gradually be reduced.
Now, once you get to that retirement phase, and now yes, you’re going to switch from worrying about mortality risk to worrying about longevity risk, then you want to use annuities to create that income stream. On the annuity side, there’s a lot of confusion about what exactly is an annuity, because there’s a type of product called a variable annuity, which is not really an annuity. It’s an investment product that can be converted to an annuity at some point in the future. However, you can buy really plain-vanilla annuities that are available. You always, of course, as with any insurance product, you have to look at how much it’s going to cost you. But if you can get just a plain, simple payout annuity at a reasonable price, that would be the direction to go.
Ptak: Tom, one risk you address is longevity risk. How does the model help individuals and advisors plan for the uncertainty of life expectancy? We talked about that on a related topic, which is, mortality insurance, but specifically on longevity. Curious your thoughts on that and maybe also some actionable insights for retirees to ensure they don’t outlive their assets?
Idzorek: Sure. So, again, we discussed the concept of maximizing lifetime utility, which is looking at all of the periods in the future where the person could be alive and incorporated into that model is a model of, we don’t know how long the person will live, but there is a probability that at any given point in time, that they might pass away and or that they would be alive. And then I think this is actually another strength of the model is that schedule of probabilities of that person being alive at any given point in the future can be personalized for that individual based on their unique knowledge of their health situation and perhaps family members' longevity. In terms of actionable insights, what can people do? Well, I would just say you got to go run some numbers. You could use one of the online calculators to see how they’re doing. Obviously, you could go meet with a planner and then, as Paul was just talking about, one option is to buy a real annuity. And then should one choose not to use annuities, then you of course, have to be willing to alter your consumption depending upon how your portfolio is doing.
Benz: So what changes do you think are needed in the financial advisory industry to implement such a comprehensive approach as we’ve been discussing here today? Paul, perhaps we can start with you on that. And then, Tom, maybe you can chime in.
Kaplan: I think the first thing is that financial planners would have the option of using some kind of software system, which is based upon the models that we describe in the book. And, then they could put it into action. But perhaps also with that maybe some change in the education of financial planners, because I don’t think lifecycle finance is actually taught to financial planners. And yet it is so foundational to what they might do. I’m thinking just by analogy, I can remember, like taking a course in chemistry, but before you get into the chemistry part, you first have to learn the model of the atom, because that’s fundamental. You have to understand the atom first before you can understand molecules and chemical properties and all that kind of thing. So, I guess another thing would be, in addition to software, somehow working this into the education of financial planners.
Idzorek: It’s a picking up more on the industry side. To me, so many of the integrated larger financial-services companies, they often have a retirement business and a wealth business. And I guess, to me a core concept within lifecycle finance is trying to be holistic and to holistically manage all of the assets of a person given their situation. And I guess I feel like there are barriers where one bucket of money, one pocket of money is getting perhaps managed one way within their 401(k). And then separately, other money is being managed by a wealth advisor. And of course, there’s great advisors and great planners that are able to overcome that hurdle. But I do see that hurdle as a real one in terms of really acting holistically in the best interest of investors.
Ptak: So for our last question, I wanted to shift gears a bit and talk about a topic that’s unrelated to the book that we very much enjoyed talking to you about the book and exploring it. And that’s John Rekenthaler. John Rekenthaler, our colleague, recently announced that he’s retiring from Morningstar after a very distinguished and long career during which he’s worked with, collaborated with, with both of you. So I wondered if maybe you wanted to offer any sort of reflections on the experience that you had working with John through the years. Paul, maybe we’ll start with you. And then Tom, if you’d like to contribute too, be interested in your perspectives too.
Kaplan: Back in 1999, John hired me. And I really enjoyed working with him. Initially, we were working on our online advice system. And then, I also had the opportunity to work for Don Phillips for a couple of years, and then John again. And, in my mind, Don and John, they really contributed so much to Morningstar, really being the face of Morningstar to the financial planners and investors. And I always enjoyed all my time, for the 25 years, starting 25 years ago, working with John.
Idzorek: And so I’m happy to chime in as well. Jeff, you sent out an email internally last week, and announcing John’s planned retirement. I’ll just say I was very surprised. And I guess one of the reasons I was so surprised is that, ironically, I guess Paul and I had been on a call just days earlier with John, pestering him, ironically around some of the work of Paul Samuelson and how to interpret it, and again, I was worried that we were really pestering John. But we talked about retirement and what that might look like for John. And of course, Paul has been retired for a year-plus now and what life is like. But to echo what Paul has said, in my mind, and Christine and Jeff, I’d almost be interested in your opinions as well. But, for all of us at Morningstar, it’s hard to think of outside of, first I guess, Don Phillips and then John, who has had a more profound influence on the firm, I guess, Joe and Kunal. But, from a research lens, thinking about how do we act in the best interest of investors? Again, I think of Don and John as really being the people that have created the fabric of Morningstar. And so I’m sad to see John retire, but luckily, I know how to reach him, and I plan to reach out often.
Ptak: Well, I think I speak for Christine in saying we couldn’t say it any better. We very much echo those sentiments and maybe we’ll close on that note. I just wanted to thank both of you, Tom and Paul. It’s been a very enlightening discussion. Thanks so much for your time and insights. We very much enjoyed chatting with you.
Idzorek: Thanks.
Kaplan: Thank you.
Benz: Thanks to you both.
Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts. You can follow me on social media @Christine_Benz on X or at Christine Benz on LinkedIn.
Ptak: And @SYOUTH1, which is S Y O U T H and the number one.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week. Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at thelongview@morningstar.com. Until next time, thanks for joining us.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates, which together we refer to as Morningstar. Morningstar is not affiliated with guests or their business affiliates, unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. This recording is for informational purposes only and the information, data, analysis, or opinions it includes, or their use should not be considered investment or tax advice and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from or related to the information, data, analysis, or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision. Please consult a tax and/or financial professional for advice specific to your individual circumstances.)