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How do we incorporate human capital into a more holistic look at asset allocation? John Thompson, Vice President and Portfolio Manager at Ibbotson Associates, a Morningstar company, asks the audience of the Morningstar Investment Conference. Normally in order to assess an individual, one looks at their capital and savings, conducts a questionnaire to assess their risk appetite, discusses their time horizon, looks at liquidity and talks about tax registers. But the one thing they may not explicitly address is human capital. Implicitly, yes, but not explicitly, Thompson says.
So how do we define the concept of human capital? Simply put, it’s an individual’s ability to earn and save, Thompson said, and is calculated by looking at the present value of the individual’s future earnings, i.e. their earning power, plus their savings, pension and state pension, and so on. Human capital is used not only to fund current expenses but also to plan and fund future investments; it is a concept that is very innate and individual to each investor, he adds. Younger investors have more human capital than older investors in that their salary is set to increase and to continue for many years, but older generations also have human capital with many people choosing to work well beyond 60 years of age.
Thompson shows a graph that displays how the typical life cycle of human capital and financial capital overlap but tend to rise and fall at different stages of life. Human capital starts high and diminishes over time. For example, someone fresh out of university has a lot of human capital – saving and earnings power. Financial capital follows a different pattern, it builds gradually and starts to diminish as the individual’s investment returns diminish relative to their expenditure.
Longevity, and the probability of living to ripe old age, needs to be factored into any calculations of human capital, but so does the type of human capital. Some individual’s human capital may act more like an equity, whereas others may be notably bond-like. A 30% equity/70% bond portfolio simulates the average earnings of an actual individual, Thompson says, noting that most of the delegates in the conference auditorium are probably stock-like in terms of generating income because their income depends to a certain extents on the markets, given that they work in asset management. Compare this, however, to a university lecturer, for example, which could be seen as more bond-like, with wages very steady and probably increasing only marginally but at a steady pace.
Turning to the notion of total economic wealth, Thompson highlighted the importance of combining life insurance with an individual’s asset allocation strategy so as to protect their human capital while optimising the mortality-risk adjusted economic value of their portfolio. For example, if the bread winner of a family was to die, their family would lose his/her human capital and be left with only the financial capital if no life insurance was in place prior to their death. With life insurance they maintain are able to maintain both the financial capital and the human capital as the latter is protected.
Young people need to be less concerned about market risk, Thompson says; if they have a well-diversified portfolio they can recover from crises like that which we’ve seen in recent years. The most important thing is still to save, save, save, he adds, but they also need to protect their human capital and grow their financial assets (and human capital). And what about older savers? These need to be more focused on the market and on protecting their assets from market risk, especially tail risk, Thompson says, noting that investors need to ensure their money lasts a lifetime.
Investors and their advisers need to think less of human capital as an implicit concept and instead use it as an explicit concept when building portfolios. In addition, they also need to remember that annuities can provide lifetime protection when you most need it.
Asked by an audience member whether most investors have a pension retirement shortfall, Thompson replies that yes, some do, but what is more striking is that most actually have exaggerated expectations. They may have saved, says, £100,000 and they think that’s a lot. But when they look at how much their earning, say, £50,000 per annum, and then you ask them how much they spend each year, and they realise it’s £50,000 it dawns on some savers that actually that £100,000 isn’t going to last long. Misunderstanding and exaggerated expectations are perhaps more important in themselves than a shortfall in savings, he concludes.
