When it comes to managing household debt, many people turn to high-interest and tax-inefficient options, such as carrying a monthly credit card balance or engaging with alternative financial services. Past research has found that individuals who use these types of consumer debt products tend to be financially constrained and faced with an immediate liquidity need, and that they generally have lower levels of financial literacy.

Much less is known, however, about the role financial literacy may play when a more advantageous solution may be available but not used. One example of such a solution is a securities-based loan (SBL), which allows investors to borrow funds against the value of their portfolio, using securities such as stocks or exchange-traded funds as collateral. While SBLs typically offer lower rates and potential tax advantages when compared to credit cards and other debt products, there are, of course, risks to consider – primarily the risk that market volatility can magnify an investor’s potential losses.

Rather than explore the pros and cons of SBLs, this article focuses on research Janus Henderson recently conducted in partnership with Liberty University School of Law and Kansas State University. Our study -the findings of which were published in Financial Planning Review in June 2023 – sought to understand why certain investors might opt to use traditional debt management products when they could have qualified for an SBL as a source of credit. Specifically, we wanted to determine whether two factors – financial knowledge and the use of a financial advisor – made individuals more likely to use an SBL.

Financial advisor use has been shown to benefit clients

The first factor we examined – the use of professional financial advice and its potential benefits to clients – has been researched extensively. Just as advisors have been shown to help investors make more informed decisions around goal setting, staying invested during periods of volatility, and saving for retirement, we hypothesized that financial advisor engagement would be positively associated with using an SBL to manage household debt.

Bounded rationality can lead to irrational decision-making

In considering the second factor, financial knowledge, our research was guided by a theoretical framework known as bounded rationality. The theory posits that humans are limited in their ability to gather, understand, and remember information due to complex environments, limited mental capacity, and finite resources, such as time and money. To cope with these limitations, individuals employ simple rules of thumb or heuristics when faced with complex problems. The use of these mental shortcuts can lead to irrational decision-making and suboptimal behaviors – including poor choices regarding over-indebtedness.

For this study, we hypothesized that the use of inefficient debt when better alternatives were available was also attributable to bounded rationality. For example, consumer debt users may have simply been unaware that a better solution was available. Or, even if respondents were familiar with SBLs, they may have lacked the financial capacity to take full advantage of this option.

Findings and implications for financial professionals

As expected, the study found a positive relationship between objective financial knowledge and securities-based loan use. It also found a positive relationship between financial advisor engagement and the use of SBLs.

The results from this study have important implications for practitioners – first and foremost, the value a financial professional can provide to clients.

Financial professionals can help close clients’ objective knowledge gap by providing important and timely information about SBLs and other debt management tools. Advisors may also be able to help clients assess their options and make an informed selection. As investment management has become largely commoditized – and even faces continued pressures from automation, artificial intelligence, and the like – providing these services is an important way for advisors to differentiate themselves.

A second implication is the potential use of SBLs to establish or increase an emergency fund. Prior research did not find evidence that the ability to borrow against a retirement plan was a substitute for an objectively calculated emergency fund. This could be because investors may be hesitant to access a retirement loan because of restrictions on the amount or use of the loan. Investors may also be concerned about the potential impact on their long-term needs in retirement.

Beyond using SBLs as a source of credit or substitute for an emergency fund, there are several possible applications for ultra-high-net-worth investors. Company founders and other corporate executives can use an SBL to meet various expenses while avoiding a capital gains tax that would be triggered upon a sale of appreciated stock. Although the stock is pledged as collateral, clients continue to maintain voting and dividend-distribution rights. Additionally, the stepped-up costs basis is preserved if the shares are held until death and bequeathed to a recipient. In these instances, consultation with corporate counsel will be critical to make sure any company and regulatory requirements are fully satisfied. The client’s outside tax and legal experts will also need to be consulted, offering financial professionals familiar with SBLs an opportunity to differentiate their practice among a group of highly regarded centers of influence.

Lastly, given the present climate of raising interest rates and tightening credit, advisors can add value by offering strategies for creating alternative sources of credit. Refinancing existing consumer debt into an SBL may be less expensive and possibly tax-deductible, which could help clients save money that can be redeployed into their investment or retirement accounts.

 

IMPORTANT INFORMATION

Volatility measures risk using the dispersion of returns for a given investment.

Tax information contained herein is not intended or written to be used, and it cannot be used by taxpayers for the purposes of avoiding penalties that may be imposed on taxpayers. Such tax information and any estate planning information is general in nature, is provided for informational and educational purposes only, and should not be construed as legal or tax advice.