Diminished capacity creates new investment risk

The aging of the U.S. population presents both challenges and opportunities for the financial services industry. Adults over the age of 50 control more than 80% of U.S. assets. Meanwhile, nearly a quarter of Americans over age 65 experience some form of diminished mental capacity, putting them at risk for poor financial decision-making and exploitation.

A new white paper released Tuesday at the annual meeting of the American Society for Aging details how financial advice companies can better support at-risk aging clients. The paper summarizes current demographic realities, the nature of the risks to financial services firms, the regulatory environment and the opportunities for firms seeking to better protect their clients and themselves. It was written by Chris Heye, founder of Whealthcare Solutions Inc., Liz Loewy, co-founder of EverSafe, and Katherine L. Wade.

Financial advisory firms will be increasingly challenged to help clients as the demographic age wave continues rolling into retirement. The median age of the nearly 70 million baby boomers hits 65 in 2021, and the oldest boomers are now 75, an age when the risks of cognitive, behavioral, and financial literacy issues can multiply.

These demographic shifts require advisers to be more proactive in addressing a new class of risk: the financial risks associated with aging. A major study published in 2009 that examined financial decisions over people's lifespans concluded the peak age for financial decision-making occurs around 53, indicating that the majority of advisory clients (as well as many advisers themselves) are already well past their decision-making prime.

An estimated 10% of adults over the age of 65 are currently living with Alzheimer’s disease, and another 15% to 20% of those over 65 suffer from mild cognitive impairment, meaning that 25% or more of financial advisory clients are at risk for diminished capacity.

Diminished capacity poses risks not just for individual clients, but also for wealth management firms. The paper listed six major risks associated with managing clients with diminished capacity, including the loss of some or all of a client’s current assets under management and the loss of the opportunity to consolidate held-away assets as declining client satisfaction leads to switching financial advisers.

In addition, the aging of the baby boomers is expected to result in roughly 45 million households transferring more than $68 trillion to heirs and charities over the next 25 years. What will the heirs do with their inherited money? Probably not keep it with their parents’ advisers. An estimated 87% of heirs fire their parents’ financial advisers and either manage the money themselves or move to another investment firm.

“Diminished capacity is invariably a highly sensitive subject within families,” the white paper said. “If an adviser has a good relationship with his client’s children, and if they can demonstrate that they did everything they could to protect the parent from health-related risks like diminished capacity, the adviser will have a better chance to hold on to the assets of the deceased client.”

Strategies are needed and practical capabilities required to assess and evaluate the risks faced by aging clients and their families. Companies can take steps to protect clients proactively by offering tools that warn clients of potential risks and fraud, but these highly personalized client communications will likely require technology upgrades and business reorganizations that will take time and money.

Diminished capacity cases also expose firms to mounting regulatory risk. In the past five years, the Financial Industry Regulatory Authority Inc. has implemented several rules focused on senior investors, including requiring the collection of “trusted contact” information, and states have implemented their own rules to address the potential exploitation of elders.

Last year, the Advisory Council on Employee Welfare and Pension Benefit Plans released a report to the Secretary of Labor that lays out the most comprehensive set of recommendations for protecting older adults from financial exploitation, including providing mandatory training for staff; offering protected account features allowing clients to set alerts for specified account activities and provide read-only access to authorized third parties; and employing technology to identify changes in behavior like a change in the risk profile.

“We recommend that firms view diminished capacity the same way they would perceive any other risk that threats 25% or more of their business,” the authors of the white paper concluded. “Time and money spent protecting clients and preparing them for the day they can no longer safely manage finances on their own is likely to be a valuable investment over time.”

(Questions about Social Security rules? Find the answers in Mary Beth Franklin’s ebook at InvestmentNews.com/MBFebook.)