Comprehension Not Disclosure

Despite all reports to the contrary, I have not suspended my campaign for National Personal Financial Benevolent Dictator (NPFBD). 

In fact, today I add a new plank to my platform.

My latest plank is regulation through comprehension, rather than through disclosure. I’ll unpack what I mean by that below.

I’m in the process of renewing the Home Equity Line of Credit (HELOC) on my house. 

As you can imagine, my mailbox and email box filled to the brim with dozens upon dozens of disclosure document pages for my signature. These are virtually unreadable and they will go unread by me. Nevertheless, I will sign them.

Lauren Willis, a law professor whose criticism of financial literacy programs I recently described admiringly, has a replacement for these disclosure documents, and I’ve stolen her idea for my platform.

She argues in a 2017 paper “The Consumer Financial Protection Bureau and the Quest for Consumer Comprehension”  that financial products regulation should focus less on disclosure and more on creating a system of consumer comprehension. 

Here’s what she means. Financial service providers – of credit cards, insurance, investments, and mortgages – would need to regularly show to regulators that a large majority of their customers could pass a simple comprehension test about their product. 

Placing the burden on financial firms to stay consumer compliant is analogous to requiring car companies to prove they can meet emissions standards, or toy manufacturers can meet child safety standards.

As long as, say, 80% of credit cards users could ace a quiz about what their interest rate is and the cost of their late fees, and maybe also what the mandatory arbitration clause means, the credit card company would be in the clear. Or, as long as 70% of insurance buyers could accurately describe the meaning of their deductible, premium, their coverage and exceptions, they are good. Provided that 85% of mortgage borrowers correctly describe in a quiz their terms and what their payments will look like if the adjustable rate changes in 3 years, the product is fine.

I’m making up these numbers and these requirements just to provide some sense of what a consumer-comprehension quiz would look like. The point from Willis is two-fold: Disclosing terms in tiny print over 30 pages never helps. It leaves the burden on the consumer. Instead, the burden should be on the firm to show – with a consumer comprehension audit – that customers know what they are buying. After all, isn’t that the original point of these non-effective disclosures in the first place? 

Our default system is free market. And I’m a free markets guy. I like classical economics’ trust that prices and quantities will reach equilibrium as long as we minimize frictions like taxes and government interference. Few people will purchase a $10 tomato when a $1 is available, says classical economics. Firms able to offer $1 tomatoes will sell many more units than a purveyor of Gucci tomatoes. I understand this concept very well.

But the last forty years of behavioral finance has taught us that classical equilibrium theory doesn’t work as well in areas like personal finance, because of predictable inherent biases and errors of thought. As a result, people are unknowingly purchasing $10 tomatoes when they should, logically, be buying $1 tomatoes. The inefficiency endures because of human error in predictable, repeatable, ways. And if we know these errors in advance we should build in protections.

And yes, regulation like this could be expensive to firms.

But the alternative is not free market efficiency. The alternative is people paying for $10 tomatoes out of predictable ignorance.

Lauren_willis
Professor Lauren Willis

As NPFBD, I am used to people not understanding the brilliance of my proposals at first glance. But I am both benevolent and a dictator, so I will further explain and address your concerns.

One objection: Some people just can’t be taught, because math is hard. And financial concepts are especially hard. Ok, true. But Willis’ proposal focuses on setting a target for average comprehension. Like maybe just seventy percent of customers have to pass the “comprehension audit.” Not everyone. Just a good majority. That seems reasonable and flexible to me.

Another objection: Comprehension seems costly for firms, as they would be required to create educational programs around their products. Maybe. But wouldn’t it also seem that firms facing the potentially high cost of consumer education would be greatly incentivized to simplify these same financial products? Wouldn’t firms pivot towards selling things that any fifth grader could understand? 

I am certain, for example, that variable annuities would rightly disappear from the face of the earth if insurance companies were forced to educate consumers about how they actually work. Because, quite simply, they cannot be explained in simple terms. 

You know what else is costly? 25% of sub-prime mortgage borrowers defaulting in the same year, sending the world financial system into a tailspin, and requiring an unlimited bailout of all of Wall Street.

Another objection: True financial complexity cannot be captured in short consumer-education segments. Willis addresses this by analogy with energy-efficiency regulation. Simple labelling with stars currently informs us consumers of energy-efficient dishwashers and refrigerators. I don’t have to be an electrical engineer to understand the energy-efficiency star system. I just need to know enough about how the labelling of stars on my dishwasher works. A simple and consistent labelling system for credit cards, mortgage, and investment products could go a very long way to building consumer comprehension.

This is a results-oriented approach to regulation. It’s not about the number of pages of fine print. It’s about proving – with reasonable room for variation – that people using the products actually know what they’re getting and at what price.

behavioral_finance

I’m knowledgeable enough about behavioral finance to know that the unfettered free market will lead to worse results for many. But I’m cynical enough to recognize that traditional financial product regulation – in the form of more disclosures – creates an ever-increasing paperwork and liability burden on businesses, but without addressing the core problem. 

I don’t read disclosures even on my own HELOC application. In fact, nobody does. This creates a “You pretend to disclose, while I’ll pretend to be protected” universal cynicism toward the regulation of personal financial products.

As your NPFBD, I’ll focus less on disclosure and more on consumer comprehension instead.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related post

My Campaign For NPFBD – Focus on retirement investing

Renewing my HELOC in 2015 – Judgement vs. Objectivity

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Thy Will Be Done – And Do it NOW

Editor’s Note: This post ran as as newspaper column in the beginning of March 2020, before it was clear the imminent threat that COVID-19 posed to everyone’s health. So…this message just got a lot more urgent since the beginning of March.

In December 2017, my friend, who I will call LM, and her sisters visited their elderly father for Christmas. During that visit, he verbally expressed a few wishes to her, just in case something should happen to him.

At the time, he had gone so far as to have a will drawn up, but he had not finalized a plan with his official signature. In addition, he had not authorized anyone with a durable power of attorney, in case of illness.

LM is not sure if he didn’t finalize papers with his signature due to a psychological block around facing his mortality, a mistaken idea for saving money, or hesitation around who should use his apartment if he died. All she knows is that he’d done 99% of the process, but didn’t complete it.

A week later, in January 2018, he fell ill and was hospitalized. Then, family hell broke loose. The story is a bit complicated, as these stories always are. As Tolstoy wrote in the beginning of Anna Karenina, “every unhappy family is unhappy in its own way.” Like other 19th Century novels, LM’s story stems from contested estates, suspicion between family members, and expensive legal processes.

LM’s father’s girlfriend became verbally abusive. LM’s aunts – LM’s father’s sisters – were suing LM’s father, in the mistaken belief that LM’s father – as trustee of their father’s trust – was collecting more than his fair share, while their father LM’s grandfather was still alive.

Meanwhile, paying for her father’s care during a 2-months’ long hospitalization became complicated. Without a written and signed power of attorney, and in the face of a draining lawsuit and logistical difficulty even making health care decisions, LM and her family had to declare a “conservatorship” for her father’s assets. Her father died at the end of February 2018 without a will, and with his estate under legal attack from his own sisters. 

Tanya Feinleib, an attorney and shareholder at Langley & Banack in San Antonio, board certified in estate planning and probate law, says this type of “conservatorship” or “guardianship” can be an expensive and cumbersome court-supervised process.

Langley_Banack

LM describes three kinds of costs to not having a will and power and attorney at the time of her father’s death. The first is in time. 

LM’s father died in late February 2018, two full years ago. She and her two sisters have only just this past month settled the probate case, and settled a lawsuit with her aunts. Two years is a long time to remain suspended in an uncomfortable legal process with family members, made worse by the mixture of mourning, family strife, and uncertainty.

The second cost is the most obvious one, dollars drained from her father’s estate. LM calculated that her father’s estate paid 13 times more than necessary, for lack of a power of attorney. She calculates that her father’s estate paid 3 times more than necessary for lack of a will. When she includes the costs of settling the lawsuit with her aunts, more than 30% of her father’s estate was lost due to a combination of unclear communication and unfinished estate planning. Over half a million dollars remained suspended in probate, and then drained by a third, over two years. 

But the third cost, LM says, was the worst.

LM told me, “What’s even more tragic are the physical, psychological and spiritual costs of siblings who used to love each other growing to hate each other. All of that stress physically manifests in them. The worst cost imaginable to me, would be to be so insanely angry with a sibling that you couldn’t find it in you to forgive them, to say good-bye to them on their deathbed or even attend their funeral. That still makes me cry when I think about it.”

A 2016 Gallup poll found that just 44 percent of American adults have a will Of course this number varies by age, with only 14 percent of those aged 18-29 having a will (Millennials, amirite?), and 68 percent of folks over age 65 with a will. (Ok, Boomer) I’m now talking to the 32 percent of you without a will. What are you thinking? Do it. Do it now.

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You should expect the cost – for a family without complicated trusts or an ultra-high net worth – to range between $1,000 and $2,500 to prepare a will and power of attorney documents. Expect on the low end for single people without dependents. Higher for more complex families and estate requirements. Feinleib says that there are legal aid providers in many cities, including Houston and San Antonio, that offer free wills and powers of attorney for people who qualify. Some employers offer an employee assistance program for free or subsidized time with an attorney, which could be used to get your will done.

It may be tempting to try to save money without an attorney. Feinleib says web-based or artificial intelligence will-preparation could happen in our lifetime, but don’t rely on that yet. 

“For now, with respect to handwritten wills and off-the-internet wills” Feinleib warns, “When they go wrong, they tend to be extremely expensive on the probate side.”

My friend LM’s main reason for speaking with me about the details was to encourage other people to get this done right away. To not let her family’s heartache happen to other families.

Feinleib says “I think it’s the most loving thing you can do for your family. Your incapacity is going to be one of the worst moments of their life.” By properly preparing for that time, she says, you give your family a great gift.

The costs and some of the heartaches endured by LM and her family were avoidable. Says Feinleib, “every person needs to have a plan in place for who will make decisions regarding health care if they become incapacitated.”

Would you like to know the worst, ironic part of this? Even two years following her father’s death, even after years of expensive litigation, LM’s own mother has still not prepared her own will. LM herself is a certified financial planner, and one of her sisters is an attorney. And they still can’t convince their own mother to prepare her will. After the last two years of probate hell and family struggle, LM was in a state of near-disbelief when she told me this, caught somewhere between shock and bursting into tears.

A version of this post ran in the San Antonio Express-News and Houston Chronicle.

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