From the May 2013 issue of Research Magazine • Subscribe!

Investing for a Lifetime With Life-Cycle Investing

How Paula Hogan turns life-cycle theory into advisory practice.

A decade ago, Paula H. Hogan had one of those incredible a-ha moments—and her financial advisory practice has never been the same. This was no fleeting “I coulda had a V8!” epiphany. It was profound, with deep implications for the advisor’s business—perhaps even for the entire financial services industry.

That insight hit when the FA, founder and managing member of the Milwaukee-based firm bearing her name, read a couple of eye-opening Financial Analysts Journal articles written by economists: one story by Zvi Bodie, the other by Robert Merton. Both were about life-cycle investing, a school of thought that seeks to optimize income and spending, matching investment risk to goals.

Immediately, Hogan realized that application of this investing philosophy would be the best way to help her clients to safely achieve their goals.

“I thought, ‘This makes sense! It’s not what the industry is doing, but it’s what we should be doing!” says the scholarly Hogan, a Princeton grad with a master’s degree from Harvard.

The advisor indeed wasted no time in transitioning her then-11-year practice to focus on life-cycle investing. And, in an innovative move, she went a step further to meticulously pair the economic theory with the client-centric life-planning method, which integrates personal values with the management of human and financial capital.

Repeatedly named one of the country’s top advisors by a variety of publications, Hogan, 59, sees the marriage of these two disciplines as the clear direction in which financial planning is headed.

“Pulling the two threads together—life-cycle and life planning—is the future of financial planning,” says the advisor, who won a distinguished service award from the National Association of Personal Finance Advisors in 2002 and is a frequent speaker and author.

Hogan’s approach is certainly not the mainstream advisory model now, but she firmly believes it is on the way to becoming standard.

“We’re evolving from product as an advisor’s focus to having a coherent economic theory that makes sense when we sit down and talk to a person about their money. That is what we should be doing,” she says.

Practical Philosophy

Hogan’s idea of combining life planning with life-cycle brings the investment theory into the real world: that is, the advisor working with actual clients.

Most importantly, life planning—drawing mainly from positive psychology, which encourages people to have more fulfilling lives—prompts clients to articulate what they care most about, along with the needs and wants they deem critical as they move into retirement. It is information that is required to effectively implement life-cycle investing: before specific goals can be set, clients’ values need to be clarified.

It’s a rare advisor who is taking a life-cycle point of view. And by integrating life-cycle with life planning, Hogan is way ahead of the curve. This spring, a July 2012 paper she co-authored with advisor Rick Miller, “Explaining Risk to Clients,” is expected to be released as part of a book of symposium proceedings from theWhartonSchool’s Pension Research Council.

A certified financial planner and chartered financial analyst, Hogan manages assets of $199 million from a mix of clients. The RIA has two other advisors in her fee-only practice and is in the process of hiring another.

Prominently displayed in her office is a big poster showing a “Personal Wealth Flow” diagram that Hogan created. Expressing life-cycle investing visually, it plainly shows that the client—not the portfolio—is at the center of her process. The schematic illustrates that money coming in must equal money going out. Writing in the June 2012 Journal of Financial Planning, Hogan described that as a “delicately, finely tuned, always-in-motion system.” She refers to the diagram with prospects and in most every client conversation.

At its heart, life-cycle investing is the theory of how an individual should go about creating life-time financial security.

“You’re matching a coherent economic theory with what the client wants to do. Life-cycle is about optimizing everything, [especially] your future self,” Hogan stresses.

When used for comprehensive financial planning for individuals, life-cycle also applies principles from the pension world. In this goals-based investing philosophy, goals are funded in priority order.

“No matter who you are, you have a limited amount of money. So you want to make sure that the goals you care most about are funded before you run out of money,” Hogan notes.

The cornerstones of life cycle are: (1) human capital—what people do in the world with their skills and talents, and how they are remunerated and (2) that most people care more about lifetime standard of living than about portfolio wealth.

These priorities change the focus of attention from the portfolio to the client and in so doing, from return management to risk management.

Earned income and spending are Hogan’s financial planning touchstones.

From Day One as an FA, she intuitively took a life-planning viewpoint; but it wasn’t until transitioning to life-cycle that Hogan began to overtly, systematically incorporate it into her process.

The be-all and end-all of that process is not to grow a great-big portfolio. Rather, the crux of the matter is what clients care about deeply, their resources and the risks they can afford to take.

“And then we’ll build your portfolio around that,” Hogan says. “It isn’t: ‘You need money. Let’s take some risk and build a big portfolio, and I’ll hold your hand and talk you through if there’s more volatility than you can handle—and it’ll probably turn out all right.’ That [last part] really isn’t such an outrageous statement if you believe that stocks are not risky in the long run. The problem is that stocks are risky in the long run.”

Whereas in the traditional model, “the advisor will likely be selling stock,” Hogan says, in the life-cycle model, “the holy grail for product is probably going to be life-time inflation-indexed income from a diversified selection of strong counterparties.” That is, lifetime immediate annuities.

With life-cycle, the goals that clients care most about must be funded safely. So when investing for “needs,” even compared with the traditionally safe U.S. Treasury bill, lifetime immediate annuities stand out. They “[go] up with inflation but never down,” Hogan writes.

Still, “immediate annuities are almost as volatile as stocks,” she cautions. “So if you’re not doing competitive shopping, you’re not getting best execution.”

The distribution channel that has “changed everything in the immediate annuity market,” she says, is Income Solutions (www.incomesolutions.com), a purchase program of Hueler Investment Services that is the first of its kind, according to Hogan.

“The contracts are from strong insurance companies; and because it sells the annuities on an apples-to-apples basis,” she says, “I receive a market-determined price.”

As a structured product, the inflation-indexed immediate annuity surely dovetails with the life-cycle approach. Both structured products and derivatives—which allow for specific tailoring to client needs—permit risk not only to be diversified but sliced, diced and traded.

Indeed, because of the availability of such vehicles, Hogan says she is seeing a huge shift in the risk paradigm tantamount to the revolutionary change that occurred in 1952 when economist Harry Markowitz initiated Modern Portfolio Theory. Prior to that, risk was assigned: widows and orphans got safe investments, like government bonds; business executives got risky stocks.

“Part of our challenge is to say to a client, ‘What risk do you want to keep, and what risk do you want to [stay away from]?’ Hogan says. “Structured products—used pretty routinely at the institutional level—are now beginning to offer that [option] to the retail investor.”

Risk management is major to Hogan’s process.

“Where the industry is right now,” she says, “there isn’t even a teasing apart of risk capacity versus risk tolerance. But someone can have high risk tolerance but be low on risk-bearing capacity.” Typically, clients don’t even know what their risk tolerance is.

“And when you put that together with the advisor’s [aim], ‘I need them to buy this product,’ the traditional paradigm is the wrong one for helping an individual do what they want to achieve,” Hogan says. “When people go in to talk to a financial advisor—which is not a legally defined term—they think they’re buying advice. They don’t know they’re talking to a sales person.”

One of the guiding principles of life-cycle is to smooth income. It moves wealth from good times to bad times in the safest way possible. Tools for “consumption smoothing” include savings, debt and insurance.

Hogan explains smoothing this way: “Because spending occurs at a different rhythm from money coming in, getting money from when you have it—because of time or circumstance—to when you don’t is important. Thinking of wealth as a reservoir—filled with cash reserves, investment portfolio, real estate interests, business interests and even debt—with money going in and out, helps you to smooth income.”

Bonded to Hogan’s forecast that life-cycle is financial planning’s future, is a vastly changed advisor role: Instead of being an authority figure, the FA will morph into “a counselor” with both technical and non-technical skills.

Already, Hogan considers herself a “facilitator”—a bridge between economic theory and what the client is trying to accomplish in blending human capital and financial capital based on values.

“Financial planning is something the client does—I don’t do that for them,” she says. “I create a path: If they’re seeing only one part of an issue, my job is to bring out the other. In a good advisory relationship, the advisor creates an environment where the client will articulate and discover their personal values. But it’s the client’s values, and it’s their discovery.”

To be sure, life planning helps clients zero in on those values and motivations. With Hogan, they emerge as the advisor probes folks to talk about their current and past financial life, what they care deeply about, what worries them, how they define success. In this “values-clarification” process, no numbers are discussed.

“‘What do you really care about?’ is another way of asking ‘What risk are you able to bear, and what risks do you not want or can’t have?’” Hogan notes.

Life-cycle says that clients care most not about portfolio wealth but maintaining their standard of living—that is, not going backward.

“People are telling you, in effect, that they want inflation-protected income. That’s the life-cycle point of view,” Hogan says.

This means the financial plan must address life-time income and longevity to ensure that income keeps up with inflation.

Therefore, the advisor adds, “you would expect the standard retirement product to be an immediate annuity that is indexed to inflation.”

After the client elucidates his or her values, Hogan schedules a follow-up meeting to show all that information on spreadsheets matched with planning topics from a life-cycle viewpoint. She then recommends a financial plan based on and custom-tailored to what the client’s human capital is going to provide.

The whole process, she says, “empowers clients because it puts them—not the portfolio—at the center.”

Life-cycle models were laid out by economists, including Paul Samuelson, Bodie, Merton and Moshe Milevsky, as early as the 1950s and on into the 1970s. “But advisors weren’t drawing on the theory,” Hogan points out.

In fact, only within the last few years was life-cycle introduced into the chartered financial analyst curriculum, according to Hogan. And it is not included in the certified financial planner curriculum at all, she says.

“That’s odd, isn’t it?” Hogan muses.

Yet she discerns “a migration” toward life-cycle investing.

“You’re seeing something that is the beginning of what I think will be mainstream,” Hogan notes.

Post-financial crisis, she has observed that clients and advisors are beginning to talk in life-cycle terms.

“They found out that stocks aren’t safe and that they do care about risk. But I think they’re backing into the life-cycle theory *ss-first, if you will. They’re not saying, ‘I’ve discovered this theory, and now I see how it works.’ They’re saying, ‘Holy cow! This [big investment loss] wasn’t what I signed up for! It’s not acceptable. And I don’t want it to happen again.’”

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