Traditionally, financial advisors focus on income and assets to assess a prospect’s financial wellbeing. If a prospect is interested in planning, an advisor will also evaluate current expenses, debt and potential liabilities, which might include college costs, long-term care and more.
We do not consider someone’s behavior and financial literacy, although some people may argue this point. It’s worth noting that financial literacy isn’t well-defined, not like the understanding of debits vs. credits, whole life vs. term, international small-cap vs. U.S. large-cap, or 401(k) vs. Roth contributions.
However, in real life, developing and implementing a financial plan often necessitates working through a client’s behavioral and educational issues. For example, some people say they want to take no investment risk, yet at the same time they want to buy more investment properties.
To you, it’s clear that their intentions are at odds. This is a red flag that you need to look deeper for the source of the confusion before moving forward. You may discover that their lack of exposure or understanding of investment risk is the actual problem. As a fiduciary, you are obligated, in my view, to assess financial literacy to get ahead of potential misalignment of intention and plan.
Financial Literacy Matters
The subheading in an article Mark Hulbert penned for MarketWatch, titled, “The Penalty for Early Withdrawals,” states, “It’s what we don’t know that we don’t know that can impact our retirements. He notes a study, “Financial knowledge overconfidence and early withdrawals from retirement accounts,” by Ohio State University researchers found that many investors are taking early withdrawals from a 401(k) or IRA “without understanding [the] possible consequences” to their “retirement financial security.” Previous research had documented that such withdrawals represent a significant loss to retirement savings and thus have a marked impact on investors’ retirement standard of living.
To test whether lack of understanding plays a role in the decision to take such a withdrawal, the researchers tested investors’ ability to answer the questions in FINRA’s National Financial Capability Study. The researchers found that only 5% of the investors who scored the highest on this test took an early withdrawal from their 401(k) or IRA, compared with 24% of the investors who scored the lowest.
FINRA’s study also shows that few Americans score well when it comes to five questions of financial literacy. The questions don’t require a calculator and are conceptual in nature. Most people don’t even get three correct. I once had a client who didn’t know a stock from a bond, and although financial literacy is finally becoming recognized as an important addition to curricula in some U.S. schools, our current clients didn’t have the benefit of such attention to this critical area when they were in middle or high school.
Meanwhile, here we are, telling people that they should invest in their 401(k) plan. Technically aren’t we really saying save into your 401(k) plan? When it comes to investing, they don’t know what they are doing. They rely on their employer’s investment committee to select funds wisely from the menu on a recordkeeper’s platform.
Comprehensive, holistic financial planners know that financial education isn’t just about investments. They explain disability and protection, life insurance, and more. Many people are unfamiliar with these terms yet are asked to make elections during their employer’s so-called open enrollment. I regularly explain to clients the peril of taxes, especially when it comes to employer-paid disability income protection. There’s so much that clients need to know, and it frequently is up to us to educate them so they can make informed choices.
Behavioral Finance Nobel Prize winner Daniel Kahneman, in his book “Thinking Fast and Slow,” posits that humans have two systems of thinking. System 1 is quick and reactive, and System 2 is slower and more methodical. As he highlights and I have found, many people are using their System 1 during our meetings when they should be slowing down and asking deeper questions to improve the quality of the information they’re using to inform their decisions.
In addition to hasty decision-making, I frequently see client specifically behave in ways that go against what they know they should be doing. For instance, they understand the perils of spending more than they make, but they spend anyway.
Then there are the people whose cultural values dictate the financial support of their siblings, and they do so at the expense of purchasing insurance they desperately need for themselves. In this case, their behavior is consistent with their values, but it’s at odds with prudent financial decision-making. Whatever the behavior the client exhibits, we have to first notice it, and then we need to take the time to address it calmly, clearly and non-judgmentally.
Integrating Behavior and Literacy
Considering financial, behavioral and educational issues isn’t quick and easy. An advisor needs to meet at least twice, if not more, with people to establish trust and connection. The client needs to understand and be comfortable with the reality that an advisor who invests the time in evaluating their behavioral and educational complexities should be compensated for this work.
It’s vital for an advisor and client to have a “meeting of the minds” about the importance of financial literacy. Many outcomes depend more on the client’s execution than on their resources. When a client isn’t implementing recommendations and the education piece hasn’t been addressed, it’s anyone’s guess why the client isn’t following through. The simplest example of this is a client not implementing because they’re nervous about the market’s ups and downs. Maybe some education would ease their mind and allow them to move forward.
Making financial literacy a cornerstone of your practice requires potentially not only a mindset change, but also the acquisition of the right tools. You might decide to incorporate FINRA’s capability study. You might want to include Money Habitudes and/or Financial DNA’s services into your delivery model. Remember that as with any tool, their use is dependent upon the skill of the craftsperson.
Advisors Must “Show Up” For Clients
As advisors, we need to also concern ourselves with how we “show up,” that is listen, when clients are upset or confused. My friend Dr. Mary Martin, a mindfulness meditation guide, teaches financial advisors how to meet and work with their own emotions as well as those of their clients. She has created a Mindfulness for Financial Advisors course that carries 7.5 CFP CE Credits.
Dr. Martin talks about “holding your agenda lightly,” emphasizing that when your intention is to listen deeply to your client, you’re allowing space and time for their needs to emerge. Maybe those needs have to do with education or letting emotions arise that are driving behavior. Either way, a client’s needs must take precedence, as they’re going to affect what happens next and whether you address them or not.
Compensation needs to reflect more time. Whether the time comes from having to address destructive behavior, emotions or poor financial literacy, that’s easier done when you charge hourly or through adjustments to subscription pricing. The Financial Knowledge study I cited earlier (including countless other studies), points to a clear return on investment for clients when paying the additional fee.
This sort of effort is part of an approach to advising that requires a new term, “Lives Under Care.” To be focused on lives under care requires more than a Series 65 registration or some number of years in the industry. It requires a different mindset and credentials.
Understanding a client’s financial behavior and literacy is a crucial part of that mindset.
James Brewer, CDFA, AIF, CFSLA, CFP® is the founder of Envision Wealth Planning and is regularly featured in the media for his financial expertise and support of socially responsible investing. His favorite part of being a financial planner is getting to meet new people throughout the Chicagoland area, and helping them achieve their hopes and dreams. Connect with James on LinkedIn.