Paula Hogan, a Milwaukee-based advisor long visible through presentations at FPA and NAPFA meetings, has laid out a model for financial planning that she argues is both more effective and more distinctive than conventional approaches.
In an article published this week in the Journal of Financial Planning, Hogan (left) attempts to integrate well-settled ideas from economics with the realities of dealing with clients in the trenches of financial advisory practices.
“Economists tend to assume that clients come into a planner’s office already knowing where their cash is being spent and able to specify concrete financial goals and the likely path of their earned income, and (icing on the cake) also to specify which expenses are lifetime needs and which are lifetime wants,” Hogan writes. “In the trenches, it is clear that none of these assumptions are true.”
But, Hogan argues, advisors are typically working on commonly based assumptions that economics disavows—for example, the idea that time diminishes the risk of owning stocks. Yes, average stock performance is positive over time, but shortfall risk increases with time, she asserts before asking: “If we offer a financial plan to a client that requires favorable stock performance to succeed, is it a plan or a hope?”
Rejecting these extremes, Hogan redefines financial planning based on a well-settled economic theory known as the Bodie Merton Samuelson theory of life-cycle saving and investing (LCSI), which seeks to optimize income and spending and match investment risk to goals.
The key effect of this paradigm shift is that “the person is the focus of attention, not the portfolio,” Hogan writes. That is because human capital is more important than financial capital in LCSI. Hogan cites Moshe Milevsky’s famous question, “are you a stock or a bond?” to remind advisors that the investment risk they take should correspond with the volatility of their earned income. She also states the “sobering” truth that “your personal gifts, and what you do with them, are the main levers for influencing your lifetime level of living.”
Given the primacy of earned income, Hogan argues it would be appropriate for planners to make a client’s pay a focus of the annual review to be tracked over time.
And because risks must be matched with goals, and goals cannot be discerned without “values clarification,” Hogan advocates “life planning as central to the advisory mission,” despite the discomfort many advisors have with therapeutic-sounding questions they view as outside their skill set. Hogan therefore calls it “imperative for advisers to develop listening and other life planning-type skills intentionally and with supervision, instead of naively on an ad hoc basis.”
Apart from the primacy of human capital, another key insight Hogan draws from LCSI is that people care more about their standard of living than their portfolio wealth. This “core tenet shifts the focus of attention definitively toward risk management, and in particular toward managing the risks of longevity and inflation, and finding downside protection,” Hogan writes.
That means that advisors need to focus on “smoothing” consumption through tools such as savings, debt and insurance. “A central challenge of managing finances for an individual is smoothing consumption—pushing cash flow around to the right time and circumstance, because awkwardly, income and expenses don’t flow in the same rhythm,” Hogan writes.
Other implications of subordinating portfolio wealth to income needs is the need for income flooring—to ensure a base standard of living—and redefining safe assets away from U.S. Treasury bills to “an immediate lifetime annuity that goes up with inflation but never down.”
In the life of the financial planner, Hogan’s proposal means that stable investments are no longer just for widows and orphans while executives get stocks. She approvingly cites the massive derivatives market and burgeoning structured products as increasing advisors’ ability to slice and dice risk and trade it to the right party.
In discussions with her own clients, Hogan talks about “smoothing the client’s ability to spend by moving wealth from good times to bad times in the safest way possible, and in a way that is consistent with the client’s values and preferences.” Her key planning levers are the client’s earned income and spending, and an illustrative diagram she uses to stimulate discussions notably shows the client, and not a portfolio, at the center of planning efforts.