For economists, human capital is the net present value of your lifetime earnings. Unless you have a large inheritance or win the lottery, it is your single most valuable asset. Economists use an estimate of your human capital as an input for financial planning models that calculate optimal consumption in a way that maximizes personal “utility”, an economic term for “happiness”. The assumption is that an estimate for human capital can be developed and used as input for financial modeling.
Financial advisors agree that human capital is your most important asset but don’t regard it as something that can be easily calculated. Once you add some behavioral finance considerations its numerical value becomes something that is best viewed as “under construction” and therefore unknown until it more fully unfolds. Advisors think of human capital as what you decide to do in the world and what society chooses to pay you for it. It is quite personal. In the loftiest sense, human capital reflects the very human quest for safety, meaning, purpose, and joy, and therefore changes from one financial life stage to another. We are in debt to economists for framing the central role of human capital in financial planning.
Economists take a person’s human capital for granted. Financial advisors suggest that you do not do that with your own human capital.
Integrating the perspectives of economists and financial advisors creates the modern way to view personal wealth management. (These ideas are more fully developed in a working paper that my colleague Rick Miller and I recently co-authored for the Wharton Pension Research Council, Explaining Risk to Clients: An Advisory Perspective.)
In this context, human capital considerations are at the heart of each of the six traditional areas of financial planning. Here are some illustrative examples.
Cash Management: Are your spending habits well tailored to lifetime earned income? Do you have sufficient cash reserves to fund potential career changes, job disruptions, and any desired retraining?
Insurance: Insurance protects the fruits of your human capital – savings as well as future earnings. Disability and life insurance replaces income that you otherwise might have earned and these coverages are often part of your employee benefit package. Having some individually purchased supplemental coverage can be helpful to the extent that employer-provided coverage is insufficient in amount or at risk of loss from a change in employment status. Long-term care insurance involves using relatively small premiums to cover the potential for a relatively large potential expense; it stretches your ability to spend savings on potential custodial expenses. Personal liability insurance protects both savings and future earnings; lawsuits target first insurance, then assets, then future earnings
Income Tax: How you engage with the workforce greatly determines the taxes you pay. The money you earn as an employee is taxed at ordinary income tax rates. As an employee, income tax planning involves making wise use of benefits provided by your employer. Business owners have more tax planning opportunities, and in particular can convert ordinary income into capital gain income by converting salary income into ownership interests.
Estate Tax: If your human capital creates more wealth than you spend during your lifetime, estate planning determines to whom it will be distributed and with what taxation.
Investments: The appropriate amount of risk to take in your financial portfolio depends on your career; the more volatile or uncertain your career, everything else being equal, the greater stability and lower risk you’ll require in financial investments. For example, those with high risk careers might invest in municipal bond ladders and/or real estate property. In contrast, those with secure pensions adequate to cover their base standard of living can afford to take more risk in their financial portfolio, if they choose to do so.
One of the challenges in personal wealth management is that one’s risk capacity, determined primarily by prospects for human capital, is not the same as risk tolerance, the amount of risk you are comfortable taking personally. It is interesting that those with secure pensions may have the capacity to take on more investment risk, but may also have personal preferences about risk tolerance that lead to conservative portfolio decisions. Parsing risk capacity from risk tolerance is a nuanced and newly unfolding subject in private wealth management. Putting human capital at the center of financial planning is accelerating this process.
Long-term Planning/Retirement: The goal of retirement planning is to spread the ability to spend money from times when you have income to times when you don’t. Economists name this central challenge of financial planning as lifetime consumption smoothing. How much you need to earn and save depends on your desired standard of living both now and in the future. A further planning consideration is the boost in personal satisfaction and joy when pursuing a career that is tailored to your personal strengths and values. “Career asset management”, a term coined by my colleague advisor, Mike Haubrich, refers to the thoughtful attention devoted to career management as a mainstream part of one’s overall financial planning.
Financial advisors know that personal wealth management gets much easier when people are in careers they like. In those instances, money seems more likely to feel adequate and/or money is easier to make.
Economists and financial advisors use different terms but are working on the same challenge, arranging lifetime finances in a way that maximizes utility (“happiness”), by first recognizing human capital as the primary asset.
With respect to your financial planning, what you do in the world and what society chooses to pay you is fundamental to your financial well-being and worthy of ongoing thought and attention.
For more detail, see our first Wealthinking blog, dated August 9, 2012, Financial Planning: It’s Not Just Business, It’s Personal and an article I wrote for the AAII Journal Human Capital and the Theory of Life Cycle Investing.
Originally published: November 14, 2012