Gamma in Action Financially Sound Households Get Advice From

Spotlight: Financial Planning Reprinted from Morningstar magazine February/March 2019

household is behaving optimally. (For example, Gamma in Action adequate life insurance may reduce available savings, but it is a vital component of Financially sound households get advice a sound financial plan for most households.) from financial planners. Financial Planners Lead the Way Of the four sources of financial information we studied, we find that households working with a financial planner made the best overall financial decisions. Meanwhile, those households working with a transactional advisor made the

GAMMA better services to households than others. To do worst financial decisions of the group. David Blanchett this, we use the six most recent reports of the Survey of Consumer Finances (from 2001 Because of potential selection bias, we cannot to 2016) to explore how financial decision-making be sure that the financial planner was the In 2013, Morningstar researcher Paul Kaplan and varies for households that use different types only—or even main—reason these households I introduced a concept we called gamma.1 of sources of information. We concentrate on five made better planning decisions. After all, better Gamma attempts to quantify the potential value decision-making domains: portfolio risk level, decision-makers might choose to use a of financial planning. As U.S. households savings habits, life insurance coverage, revolving financial planner, and not the other way around. increasingly become responsible for more financial credit card balances, and emergency savings. However, our findings do at least suggest financial decisions, such as determining how much to And we look at four information sources: planners are adding the most value among save for retirement, how to invest those financial planners, transactional financial advisors, the information sources we considered, especially savings, and when to retire, and yet typically friends, and the Internet. By dividing financial compared with transactional advisors. lack financial acumen, financial advisors advisors into two types, we can better are well-positioned to help improve household understand if any differences exist by the type We also find that households using the Internet financial decision-making. Indeed, a growing of the advice engagement. as a source of information scored second to body of theoretical research, including our gamma those using financial planners on overall financial research, has noted the potential value of The analysis focuses on the soundness of household soundness. This is noteworthy given the low advisors in a variety of financial domains; however, financial decisions versus more outcome-oriented cost of Internet information (relative to empirical evidence on the topic is mixed and variables. Therefore, for example, we want many financial advisors) and the growing use of generally suggests households that use financial to know whether a household carries any revolving the Internet as the primary information advisors do no better (or even worse) than credit debt as opposed to the household’s level source for households included in our analysis. those who don’t, especially when it comes to of wealth or savings. In 2001, only 3% of households used the investment-related domains. Internet as their primary source of financial Focusing on financial decisions allows us to: information. In 2016, 40% did. However, the better These findings may be explained in a variety of outcomes associated with the Internet ways. One explanation could be that the gCapture differences between decision- declined from 2001 to 2016, so it is not clear to empirical research, which is largely investment- making domains. what extent this relation will persist. focused, has not captured value created in other domains such as improved savings rates or gReduce issues associated with reverse All financial advice is not the same, nor are life insurance coverage. Another reason could causality (because clients with more wealth advisor types. Thus, we shouldn’t expect the value be that certain types of advisors, such as financial become increasingly attractive to financial of advice to be uniform; research that does planners, provide valuable services that advisors and it may be difficult to determine the not attempt to control for advice type may likely are not consistently captured in a relatively broad role of the financial advisor with respect to the produce biased results. financial advisor description. wealth creation). How We Conducted Our Analysis In this article, we examine this last point— gControl for the fact that higher wealth (or more Determining the soundness of financial decision- whether some types of advisors are providing savings) doesn’t necessarily imply the making for a household is obviously subjective. For

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©2019 Morningstar, Inc. All Rights Reserved. Morningstar, the Morningstar logo, and Morningstar Advisor are either trademarks or service marks of Morningstar, Inc. Spotlight: Financial Planning Reprinted from Morningstar magazine February/March 2019

our analysis, as we mentioned above, we focus holistic services are referred to as financial savings accounts, money market mutual funds, on household decisions instead of outcome- planners while advisors that are less holistic in and money market demand accounts, oriented variables. nature, and likely more transaction-oriented, by average normal income. The goal is to have are transactional advisors. at least three months’ income set aside in The analysis uses data from the 2001, 2004, 2007, emergency savings. 2010, 2013, and 2016 waves of the Survey of Decision-Making Domains Consumer Finances. To be included in our analysis, As we mentioned above, we considered five Each household in each survey has five different the respondent had to be between the financial decision-making domains: portfolio risk observations, or implicates. Each of the five ages of 25 and 55, have children, have a minimum appropriateness, savings habits, life tests are conducted for each implicate (25 total income of at least $25,000, and have at insurance coverage, revolving credit card debt, tests for a household). The results of the test least $5,000 in financial and retirement assets. and emergency savings. These are briefly for each implicate are combined, based summarized here: on implicate weights, to get a “pass rate” for the A question in the survey asks respondents about respective domain. Pass rates ranged from their source of financial information: Portfolio Risk Appropriateness 0%, where none of the implicates passed, to 100%, This test determines if the household’s retirement where all the implicates passed. The scores “What sources of information do you (and your assets are invested in a portfolio that has at the individual domain level are then averaged family) use to make decisions about saving and a risk level that would be considered prudent given to get the aggregate financial soundness score investments? (Do you call around; read the respondent’s age. For this test, the equity for the household. Demographic control variables newspapers, magazines, material you get in the allocation of the investor’s retirement assets is (for example, total financial assets) are also mail; use information from television, compared with the Morningstar Moderate Lifetime created using the implicate weights (that is, the radio, the Internet, or advertisements? Do you Index. If the equity level is within 25 percentage weighted average of the implicate values get advice from a friend, relative, lawyer, points of the index, the portfolio is deemed to be for that household), so that each household has accountant, banker, broker, or financial planner? appropriately invested. a single set of values. Or do you do something else?)” Savings Habits EXHIBIT 1 provides insight into the percentage of We use a household’s response to this question For this test, households that have some type of households that pass the respective tests to determine the financial information source savings plan are considered to have good savings for each of the six Survey of Consumer Finances for the household in our analysis. If the respondent habits. We focus on the savings habits, instead of data sets included in the analysis. provided multiple sources, we assume the the amount of savings, to simplify the analysis and first response listed is the household’s primary because of survey data limitations related to In EXHIBIT 1 , most of the tests (except for savings information source. savings variables. habits) have approximately a 50% pass rate, which suggests there is a large potential benefit We classify financial advisors into two types: Life Insurance for financial advisors to help the households financial planners and transactional advisors. This test focuses on whether the household has make better financial decisions. If “banker” or “broker” is mentioned, the face-value life insurance at least equal financial advisor is deemed to be transactional. to the total wage income of the household. All The Results We don’t include lawyer or accountant in households in this analysis have children; To determine whether financial soundness either financial advisor group because these are therefore, it is reasonable to assume that some varied by information source, we perform not professions typically associated with level of life insurance would be desirable a variety of ordinary least squares regressions. financial advice. for most households. For the regressions, the dependent variable is the average pass rate across the five domains We choose to use the term “transactional advisor” Credit Card for each household. We conduct four over “banker” or “broker” to reflect the This question focuses on whether the household regressions including different sets of available likely scope of services associated with the advice. has any revolving credit card debt at the end independent variables. Being a broker (or banker) and a financial of the month. If the household maintains revolving planner is not mutually exclusive; there are many credit debt, we assume the household is We find that households that make better financial advisors who work for a broker/dealer who making a poor decision. decisions tend to be younger, married, and white, provide comprehensive financial planning services. and to have lower incomes, more financial assets, Therefore, we assume the response to the Emergency Savings higher levels of education, and a male respondent. question is based on the nature of services being For this test, we simply divided total liquid savings, The most significant variables are financial provided, where advisors who are providing which includes balances in checking accounts, assets and years of education, both of which have

EXHIBIT 1 Room for Improvement Only around 50% of households made financially sound decisions on portfolio risk, credit card debt, and emergency savings.

Relative Aggregate Information Sources Score Across Survey of Consumer Finances Data Sets

2001 2004 2007 2010 2013 2016 of Households Meeting Target 0

20 Portfolio Risk Savings Habits Life Insurance Credit Card Emergency Savings Source: Morningstar.

positive coefficients. This is consistent with our the selection of the information source. However, where transactional advisors improve outcomes expectations as well as with past research. these findings at least imply that working affecting these results. Perhaps future research Age and income had negative coefficients, which with a financial planner can help households make can provide clarity here. is surprising and warrants greater study, better financial decisions, while working given that typically both are positively associated with a transactional advisor may actually result We perform a secondary analysis to see how the with financial sophistication. in worse decisions. aggregate scores changed across the four Financial Planner Friend Internet Transactional Advisor informationDifference sources. Thisin Aggregate analysis isScore similar vs Averageto We also find that the base demographic variables We do not know why households working the regression information above; however, explain a significant degree more of with a transactional advisorUsing awere financial making planner the as an informationinstead of looking at the individual results, we household Forfinancial each survey soundness series, we than average the thefinancial scores for worst decisions of the sourcegroups consistently studied, led households to compare the average aggregate score for each household for the four sources of information. above-average financially sound scores. information source. This suggests that while although we can speculate. One possibility is that each household based on household information the source of financial information is important, these households may have a false sense source and then control for the Survey of other household attributes were materially of confidence about their financial soundness Consumer Finances year. This approach ensures more important. because they get advice in a few domains and the average score among the four sources 2 think that they are covered in all areas— for each survey is zero. The results are included Households that use financial planners as their when in fact they are not. One problem with this in EXHIBIT 2. financial information source were making hypothesis is that households working with the best decisions of the groups studied, followed a transactional advisor were doing the worst Overall, the time-varying results in EXHIBIT 2 0 by the Internet. Households that were using in effectively every domain we considered. are relatively similar to the regression a transactional advisor were making the In other words, it’s not as if households working results, where the financial planner values are worst decisions, and households using friends with a transactional advisor were doing Usingconsistently a transactional the advisor highest or aand friend the trans- –2 were the second worst. We cannot conclude portfolio risk really well and everything else poorly; led toactional consistently advisor below-average and friend scores. are typically (and that working with a financial planner is they were doing everything poorly. It’s consistently) the lowest. the reason those households are making better possible there are aspects of households that – 20financial01 choices due to potential200 selection select200 transactional advisors that are20 not10 One notable201 item, though, is the reduction in the bias. The outcome could be endogenous to being controlled for in this analysis or other areas average score among households that use

©2019 Morningstar, Inc. All Rights Reserved. Morningstar, the Morningstar logo, and Morningstar Advisor are either trademarks or service marks of Morningstar, Inc. 2001 2004 2007 2010 2013 2016 of Households Meeting Target 0

20 Portfolio Risk Savings Habits Life Insurance Credit Card Emergency Savings Spotlight: Financial Planning Reprinted from Morningstar magazine February/March 2019

EXHIBIT 2 Planners Pay Off Over time, households that use financial planners as their information source consistently performed well.

Relative Aggregate Information Sources Score Across Survey of Consumer Finances Data Sets Financial Planner Friend Internet Transactional Advisor Difference in Aggregate Score vs Average Using a financial planner as an information For each survey series, we average the scores for source consistently led households to each household for the four sources of information. above-average financially sound scores.

Using a transactional advisor or a friend –2 led to consistently below-average scores.

– 2001 200 200 2010 201 Source: Morningstar.

the Internet. Households using the Internet sources (financial planners, transactional financial Additionally, we found significant evidence that as the primary information source scored almost advisors, friends, and the Internet). households using the Internet are making 5% higher than the average in 2001, and better-than-average financial planning decisions. households using the Internet in 2016 scored 2% We found that the quality of household decisions The potential value of the Internet as a below average (which was the worst among varies across sources but that households source of financial information and advice is the four sources considered). There are a variety using a financial planner made the best decisions, notable given the significant increase in usage of possible reasons for this. One may be that followed by the Internet, while households using a over the past 15 years, especially if its role the benefits associated with the Internet were due transactional advisor made the worst decisions. as an information source continues to increase. K largely to early adopters, and as usage has increased, the caliber and intentions of Internet We could not conclude that using a financial David Blanchett, Ph.D., CFA, CFP, is head of retirement users have declined. planner entirely explains better decision- research with Morningstar Investment Management. He is a member of the editorial board of Morningstar magazine. making of those households due to implications This gets to the fundamental issue around around selection bias. However, these selection bias that is difficult to control for in this findings do at least suggest that the potential type of analysis. This topic is also likely worth value associated with working with a financial exploring in future research. advisor could differ significantly by type.

Important Implications These findings also have important implications The value of financial advice, something we’ve for future research exploring the value of financial called gamma in the past, can be significant. advice, especially in an empirical setting. In this article, we explored how the quality of five Any kind of analysis that focuses primarily household financial planning decisions on transactional advisors may yield significantly (portfolio risk level, savings habits, life insurance different conclusions on the value of financial coverage, revolving credit card balances, and advice than one focused on advisors who emergency savings) varies across four information are comprehensive (such as financial planners).