Financial Advisor

Talk to your clients about financial constraints

Research on various financial constraints has flourished in the 21st century, but most of the literature is devoted to understanding constraints on business firms. Constraints are equally important to an individual or family’s finances, and a trained financial advisor can play a key role in helping clients understand the constraints of their own goals. This is true whether a client is looking to buy a vacation home, start a business or simply plan to retire early.

key takeaways

  • Financial constraints are things that limit the course of economic action and must be accommodated.
  • For example, your broker may restrict you from short selling, options or margin trading, which limits your investable range.
  • Financial constraints are real issues and should not be confused with subjective or emotional excuses for not following a particular action.
  • For many, retirement income becomes a limiting factor for older adults who limit spending and spending.

Types of Financial Constraints

Financial constraints are specific and objective obstacles, not general or subjective. This separates constraints and their research from common excuses like “I don’t have enough money to invest in this stock” or “I just have a hard time understanding investing.” Think of it as the difference between telling someone which highway to take between Kansas City and Denver and drawing them a roadmap with information about speed traps, bad weather conditions, or long stretches without gas stations. specific information.

For investors, financial constraints are any factor that limits the quantity or quality of investment options. They can be internal or external (the above examples can all be thought of as an internal constraint such as lack of knowledge or insufficient cash flow). Every investor faces internal and external constraints.

Some limitations are common sense. For example, every investor needs to understand their own time horizon limitations. The same is true for a client with a 5-year-old daughter who wants to save enough to finish her four years of college, is behind on retirement investments at age 50 and wants to stop working by age 70.

All client investments are subject to tax restrictions. When discussing your client’s retirement goals, be specific about the negative impact of the tax on all realized gains and income generated, including after retirement. If a client wants to start a business or invest in alternatives such as precious metals or art, be sure to highlight all legal and regulatory restrictions. High net worth clients may have special interests in charitable organizations or travel, but each has limitations and opportunity costs.

Liquidity Risk Management

Liquidity risk management is a prime example of an area that is well-studied in the business world but rarely applied in a systematic manner to individual investments. Simply put, liquidity risk is the risk that a particular economic entity (such as an individual, company or country) may temporarily run out of cash. Almost every investment involves assets that are less liquid than cash, so the investor and his advisor must consider how the investment will limit future cash flow.

Retirement planning combines four types of financial constraints: liquidity risk, time horizon, tax, and legal/regulatory constraints. If you advise a 35-year-old client to contribute $5,000 a year to an individual retirement account (IRA), understand that the person actually spends $122,500 in a non-current account over the next 24.5 years. With some exceptions, your clients will not be able to get these assets back without paying a large fee to the government.

Not spending the additional $122,500 is a limitation that needs to be clearly stated. Your client should understand the trade-off between not spending $122,500 before retirement to get more than $122,500 in post-retirement income.

Avoid Retirement Overspending

When Social Security was first created, the average life expectancy in the United States was less than 65 years. Less than half of the contributors are expected to benefit from the system. Not surprisingly, private companies could offer higher pensions in the 1940s and 1950s, when average life expectancy was much lower.

The average life expectancy for Americans born in 2018 is about 78.7 years.Longevity is a blessing and a constraint. If your client plans to live to age 85, he won’t be able to spend 10% of his retirement savings every year after age 65. Financial advisors have a responsibility to help their older clients avoid overspending in retirement.

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