Financial Planning in the Age of Climate Change
There is no shortage of financial punditry focused on the interplay between climate change and capital markets. From the risks associated with stranded fossil fuel assets to the investment opportunities linked to climate adaptation, financial professionals are increasingly integrating climate considerations into portfolio management. However, a successful retirement depends on far more than investment returns.
Traditional financial planning inputs such as income, expenses, and emergency funding are just as dependent on a stable climate as the stock market. Inflationary pressures, escalating insurance premiums, and generous government incentives for decarbonization have a growing influence over family budgets that will only increase with each passing year. In this paper, we expand the discussion about climate and money beyond investments and explore the other ways in which a warming world is affecting household finances.
“Climate hazards can cause income loss, increased expenses, and place additional burdens on American household’s savings, credit, and insurance coverage”
Property Damage
A primary residence continues to be the most significant asset for most Americans. According to the Pew Research Center, 45% of the average American’s net worth is in home equity.2 Unfortunately, real estate and other physical assets are highly exposed to climate change. Consider that one in ten Americans reported property damage from climate hazards in 2021 alone, generating ~$56.92 billion in damages.3 It’s a financial burden more families are struggling to shoulder as the average expenditure for emergency home repairs has surged more than 400% in the past three years.4 Some damages will be covered by insurance, but some will not. Financial planners should advise clients, especially those in high-risk areas, about preparing for such unexpected costs.
Number of Billion-Dollar Weather & Climate Disasters Per year in the United States
Insurance
The cost of maintaining insurance coverage for extreme weather events may create an even larger drag on household finances. Insurance is particularly ill-suited for a changing climate. Carriers can only offer policies when they can reasonably predict losses, claims, and financial liability. As climate change creates more volatile weather patterns, claims become unpredictable, and the system as we know it begins to break down. Reinsurers, companies that provide insurance to consumer-facing insurance carriers, are responding to this uncertainty by increasing rates as much as 50%.5 Frontline insurance companies are then passing the cost on to their policyholders or they are pulling out of high-risk markets altogether, further compounding the inflationary pressure by reducing competition. Consequently, homeowners in high-risk areas are experiencing premium hikes as high as 63%.5 A report from the First Street Foundation shows that a quarter of US real estate is exposed to increasing insurance premiums while warning of an “insurance bubble” in many other regions where climate risk has not yet been priced into the market.6 Prudent financial planners will ensure their clients prepare for ongoing repricing within insurance markets.
Real Estate Value
Listing agents usually don’t salivate at the prospect of selling homes with sky-high insurance premiums and histories of property damage. Therefore, climate change is significantly impacting property values. The First Street Foundation found that a homeowner in Florida who is dropped by an insurance carrier can expect their property value to decrease by 19% to 40%.6 Given the prominence of real estate within an average family’s balance sheet, this can have massive implications for financial well-being and retirement planning. Additionally, younger clients expecting to inherit wealth in the form of real estate may be surprised to see family estates worth far less than anticipated.
Disruptions to Home Insurance Markets Can Significantly Impact Property Values
Source: First Street Foundation
CASE STUDY
In 2023, a Colorado-based family experienced a one-two punch from unexpected property damage and insurance repricing. Despite living in an arid western environment, extreme spring rainfall compromised their home’s foundation and caused persistent flooding issues. Simultaneously, the home insurance carrier for their community ceased offering policies in Colorado due to increasing wildfire risk, leaving just one carrier willing to bid on the large community policy. With no other bids to consider, the community was forced to accept a premium eight times more expensive than its previous policy, initiating an alarming special assessment for all homeowners. Consequently, property values in the community have begun to fall, devaluing the family’s largest asset. The unexpected costs and turmoil have forced the family to reassess their budget, liquidate investments, and consider relocating to a more stable environment. They are currently interviewing financial professionals that can help them navigate their new financial reality.
Cost of Living
Unfortunately, climate-driven inflationary pressures are not limited to insurance premiums as food and other commodity prices are experiencing upward pressure. At this time, the trend is most noticeable in environmentally sensitive crops. For example, coffee and cocoa prices have experienced extreme price surges due to crop failures and constrained supply.7 Add in disruptions to global trade (traffic through the Panama Canal is down 40% due to drought)8, and the extremely unpopular inflation that has plagued Americans in recent years could become a fixture in daily expenditures. If these issues persist and grow as the climate crisis intensifies, clients may find that their income needs in retirement are significantly higher than anticipated.
Luckily, not all climate-related financial planning considerations are negative. Adapting to climate change and adopting decarbonizing technologies can save consumers money. For example, installing an efficient heat pump can create between $300 and $1,500 per year in energy savings for an American household.9 And such investments may be heavily subsidized through federal and state government programs. Financial planners should familiarize themselves with the credits and deductions associated with the Inflation Reduction Act (IRA) of 2022, various state incentives, and the corresponding restrictions. Here are some examples of IRA incentives for home and vehicle upgrades that can reduce long-term expenses for clients.
Source: Internal Revenue Service
Income
Some professions are more exposed to climate risk than others, and some clients may find themselves with specious income projections. For example, business models that rely on outdoor labor, such as construction or agriculture, may experience substantial losses in worker productivity. The International Labour Organization predicts that hours worked in these sectors could fall 3.8% by the end of the decade, a casualty of climate-induced high temperatures.9 Professions are often intricately tied to personal identities and it is not the assertion of this paper that financial planners should challenge a client’s choice of livelihood. Nevertheless, it is inevitable that climate change will affect the earnings of some clients and it will be in these unfortunate instances where financial planners must stand ready to shepherd clients through the subsequent hardship.
“In so many of the mathematical equations that govern our existence, constants are being replaced by variables”
Retirement Savings
While this paper aims to expand the climate-finance conversation beyond portfolio management, we cannot conclude without highlighting the fundamental risk to retirement accounts. Humanity has enjoyed a stable climate for 12,000 years, and the systems on which we depend are designed for climatic conditions that are no longer available to us. In so many of the mathematical equations that govern our existence, constants are being replaced by variables. As a result, some economists are becoming increasingly concerned that our forecasting methods are ill-equipped to fully capture the repercussions of climate change.10 Could the Monte Carlo simulations that serve as cornerstones within so many financial planning software programs be fundamentally incapable of projecting returns on a warmer planet? It’s a thorny and alarming question, yet one that financial planners must begin to consider as immunizing investment portfolios from the effects of climate change will become a critical function of advisory firms. Simple solutions will be elusive, but we recommend exploring our paper “Weathering the Storm,” where we provide some actionable ideas for protecting against climate-driven investment risk.
Conclusion
Climate change presents profound and expansive challenges, and we are not encouraging financial planners to immediately overhaul the successful processes that have long delivered so much value to their clients. Rather, we hope that the information provided in this paper helps forward-thinking planners integrate some climate considerations into their work. Below are some simple suggestions that can help advisory firms better serve their clients, differentiate themselves from competition, and capture the attention of more prospective clients.
