1. Financing Your Life
Calculating human capital to guide
your financial decisions both before
and during retirement
Vector Financial Advisors,
LLC
2. “According to the Survey of Consumer
Finances conducted by the U.S. Federal
Reserve Board (2004), the number one
reason for individual investors to save and
invest is to fund spending in retirement…
3. …and significant changes in how
individual investors finance their
retirement spending have occurred in the
past 20 years. Based on data from the
Investment Company Institute, retirement
assets reached $14.5 trillion in 2005. IRAs
and DC plans total roughly half of that
amount – which is a tremendous increase
from 25 years ago.”
- Roger Ibbotson
4. Pension Savings
25%
Retirement Income
31%
In 2001
Social Security
44%
“The U.S. Social Security Administration reports that 44% of income for
people age 65 and over came from Social Security income in 2001 and
25% from DB pensions. According to Employee Benefit Research Center
reports, current retirees receive almost 70% of their retirement income
from Social Security and traditional company pension plans whereas
today’s workers can expect to have only about one-third of their
retirement income funded by these sources (GAO 2003; EBRI 2000)…
6. Retirement Income Pension Savings
25% 31%
Around2001 …
In 2010…
Around 2030…
2020
Social Security
44%
7. Pension
Retirement Income 18%
SS
Around 2030… Savings
16% 66%
…The shift of retirement funding from professionally managed DBPs to
personal savings vehicles [IRAs and DCPs] implies that investors need
to make their own decisions about how to allocate retirement savings
and what products should be used to generate income in retirement.
This shift naturally creates a huge demand for professional investment
advice throughout the investor’s life cycle.” – Roger Ibbotson
8. 2001 2030
Pension
Retirement Income
Pension Savings
25% 18%
31% SS
Around 2030… Savings
16% 66%
Social Security
44%
…The shift of retirement funding from professionally managed DBPs to
personal savings vehicles [IRAs and DCPs] implies that investors need
to make their own decisions about how to allocate retirement savings
and what products should be used to generate income in retirement.
This shift naturally creates a huge demand for professional investment
advice throughout the investor’s life cycle.” – Roger Ibbotson
9. 2001 2030
Pension
Pension Savings
18%
25% 31% SS Savings
16% 66%
Social Security
44%
…The shift of retirement funding from professionally managed DBPs to
personal savings vehicles [IRAs and DCPs] implies that investors need
to make their own decisions about how to allocate retirement savings
and what products should be used to generate income in retirement.
This shift naturally creates a huge demand for professional investment
advice throughout the investor’s life cycle.” – Roger Ibbotson
10. 2030 Income Reduction
Pension
18% Pension
SS 23% Savings
Savings
16% SS
66% 21% 56%
Savings reduced by 33%
Ideal Retirement Income
22% Net Reduction
11. 2030 Greater Reduction
Income Reduction
Pension
18% Pension
16%
SS 23% Savings
Savings 61%
16% SS 22%
56%
66% 21%
Savings reduced by 33%
Savings reduced by 33%
Ideal Retirement Income Pension reduced by 35%
22% Net Reduction
28% Net Reduction
12. Personal Savings
Pension
18% Accumulated
SS Savings
16% Labor Income
66%
Defined Contribution Plan
(commonly a 401k)
Individual Retirement Account (IRA)
13. Professional Management
Since the mid-1950s
- Markowitz’ Mean-Variance
- Modern Portfolio Theory
- Maximum returns for your risk…
The method hinges on a correct
calculation of one’s risk – but it does not
take into account many risks that all
investors will face throughout their lives.
14. Mean-Variance Framework
‘Maximizing returns without risking too much’
12
Expected Return (%)
10
8 Large Cap
Stocks
6
4 Aggregate Bonds
Cash
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Standard Deviation (Risk, %)
15. Some Risks Not Considered
Wage Earnings Mortality
Job Security Longevity
Job Type
16. Is there an asset that these risks come from?
…and could it be incorporated into the
mean-variance framework?
17. Human Capital
“Human capital is defined as the
economic present value of an investor’s
future labor income.”
- Roger G. Ibbotson
18. Converting Human Capital to Financial Capital
1400
1200
Total Wealth
1000
Present Value ($)
Financial Capital
800
Human Capital
600
400
200
0
25 30 35 40 45 50 55 60 65
Age (years)
19. Converting Human Capital to Financial Capital
1400
Present Value ( $ Thousands)
1200
Accumulation Stage Retirement Stage
1000
800
Retirement
600
400
200
0
25 35 45 55 65 75 85 95
Age (years)
20. Converting Human Capital to Financial Capital
100
80
Human Capital
Share (%)
60
40
Financial Capital
20
0
25 30 35 40 45 50 55 60 65
Age (years)
21. Asset Allocation
(Slightly above average aversion to risk)
100
80
High Risk Assets
Share (%)
60
40
Low Risk Assets
20
0
25 30 35 40 45 50 55 60 65
Age (years)
22. Job Type
Not Tied to Stock Market Tied to Stock Market
Human Capital Human Capital
Low
Job Security
RELATIVE RISK HIGH RISK
Human Capital Human Capital
High
LOW RISK RELATIVE RISK
23. Asset Allocation
(Slightly above average aversion to risk)
100
80
High Risk Assets
Share (%)
60
40
Low Risk Assets
20
0
25 30 35 40 45 50 55 60 65
Age (years)
24. Calculating Human Capital Calculating
Dependency of Calculations Your Human
Capital
n
E[ht ]
HC ( x) = ∑ t−x
t = x +1 (1 + r + v )
x = Current age
Calculating
HC(x) = Human capital at age x
Optimizing Dynamically
Your Human Your Asset Managing
ht = Earnings for year t adjusted for inflation beforeYour Risks
Capital Allocation
and after retirement, adjusted for Social
Security and pension payments
n = Life expectancy
r = Inflation-adjusted risk-free rate
v = Discount rate (adjusted to risk level of income)
25. Calculating
Human Capital & Asset Allocation Your Human
Capital
Maximum percentage of assets
allocated to risky holdings is
max E[U (Wx +1 + H x +1 )] Optimizing
Your Asset
(α x ) Allocation
αx = Allocation to the risky asset
Wt = Financial capital at time t Dynamically
Managing
Your Risks
Ht = Human capital at time t
26. Calculating
Optimizing Life/Longevity Insurance Your Human
Capital
max E[(1 − D)(1 − q x )U alive (Wx +1 + H x +1 ) + D(q x )U dead (Wx +1 + θ x )]
(θ x ,α x )
θx = Desired death benefit
Optimizing
αx = Optimized allocation to risky assets Your Asset
Allocation
D = Relative strength of the utility of bequest
qx = Objective probability of death at end of year x+1
qx = Subjective probability of death at end of year x+1
Dynamically
Wt = Financial wealth at time t Managing
Your Risks
Ht = Human capital at time t
Ualive = Weight representing one’s ‘alive’ state
Udead = Weight representing one’s ‘dead’ state
27. Calculating
Optimizing Life/Longevity Insurance Your Human
Capital
max E[(1 − D)(1 − q x )U alive (Wx +1 + H x +1 ) + D(q x )U dead (Wx +1 + θ x )]
(θ x ,α x )
100
90 Immediate Variable Annuity
Immediate Fixed Annuity Optimizing
80 Your Asset
Allocation
70
Allocation (%)
60
50
Riskier Assets
40
30
Lower Risk Assets
20 Dynamically
Managing
10 Your Risks
0
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Risk Aversion (CRRA)
28. “I don’t care how big and fast
computers are, they’re not as big
and fast as the world.”
-Herbert Simon
29. Vector Financial Advisors, LLC
CPA, CFA is an Investment Advisor Representative. Securities and investment advisory services offered
through Ameritas Investment Corp (AIC), member FINRA/SPIC. Vector Financial Advisors, LLC and AIC are
not affiliated.
Representatives of AIC do not provide tax or legal advice. Please consult your tax advisor or attorney
regarding your situation.
Editor's Notes
Plain and simple, this presentation is about 2 types of change. The first involves changes you have no control over – particularly the changes the government and employers are making in retirement plans. And the second revolves around changes we are suggesting about how your finances are managed. These second set of changes are (in some sense) a response to the first, but also stand as sound financial advice all on their own.
[READ THE QUOTE]
[FINISH READING THE QUOTE] So, we’re going to examine some specifics of this change, and see how it may affect you.
These predicted values have been calculated by a team of market researchers and economic analysts led by the renowned economist Roger Ibbotson. [PIE CHART 2001] [READ THE QUOTE]
[PIE CHART 2030] [READ THE QUOTE]
Take a look at them next to each other…
Knowing that your ideal retirement income will be broken down according to the graph on the left, if your rate of income is 1/3 slower than you expect now, that nets a 22% cut in retirement income as a whole, and causes a greater dependence on ever-weakening Social Security and pension plans…
Additionally, if your pension plan is liquidated (which is not unlikely), you can count on a 35% reduction in defined benefit income, resulting in a net reduction of retirement income of by 28%, and an even greater dependency on Social Security. Some people may think they have sound job security, and their income will hold it’s own until they retire, but this plan considers “savings” to be made up of more than just your income.
Accumulated Labor Income is your checking/savings, real estate, and personal investments. DCP as pension plans are phasing out to make room for your 401k IRA only if you’ve set one up far enough in advance Your 401k and your IRA are both large parts of your retirement income. When they were designed to be a product that would provide you with your retirement spending money, that’s exactly what they meant. This just shows you exactly what that means, and the gravity of the situation. And we can’t say 50% is going be from your bank accounts, 25% from an IRA, and another 25% from your 401k, because this breakdown varies from person to person. But the one thing we can look at right now [CLICK] is the fact that you now have increased and unavoidable financial risk in your future. These two products require careful (and in a fickle economy - sometimes aggressive) management.
Since the mid-1950s, Modern Portfolio Theory has been a financial advisors creed. “ Diversify so as to achieve the maximum return for your personal level of risk.” You choose your level of aversion to risk (somewhat based on your current stage in life) and then your financial advisor uses Harry Markowitz’ work from the mid-20th century to maximize your investments. But, there’s one problem… [CLICK] Recent work by Ibbotson and his associates who calculated those predictions from before has indicated that significant shortcomings arise in the model when considering the number of risks that it fails to objectively evaluate. [READ THE GREEN BOX]
So here’s Markowitz’ work in a picture. An axiom for all financial advising methods is that if you take more risk, your potential for greater returns increases. Take higher risks, make more money – generally speaking. Well Harry Markowitz said in the 1952 Journal of Finance that he could objectively calculate the maximum amount that you could make based on your risk level. He said that if you pick your place along the horizontal axis (your personal aversion to risk), the bar above represents the best your returns could do. And to make your way onto that curve, there is a particular blend of assets that he could calculate to get you there. Needless to say, his work changed the world of investment finance forever. He won the Nobel Memorial Prize in Economic Sciences in 1990 by which time all major financial advising firms had adopted his philosophy of optimal asset diversification to maximize returns. And not until very recent times have some begun to question his work.
As we said before, in particular, his work has been criticized for not taking into account many risks that people could/will encounter during their lifetime. [RISK SQUARES]
[READ THE SLIDE]
Human Capital – it’s an asset which we add into Markowitz’ mean-variance framework. While usually not considered in the same context as financial advising because of its intangibility, human capital is a real asset which we are born with, we invest, we collect dividends from, we reinvest, and we can even buy insurance for. And like any other asset, it has particular risks associated with it, and these risks are neglected in Markowitz’ current Efficient Frontier calculations.
So here we go, calculations estimate that human capital is the greatest asset that any investor has until they are about 50 years old. One invests it in work, receives dividends on it in the form of paychecks, and if they choose, they may even reinvest those returns in education so as to increase the value of their human capital. With time, if ones human capital is correctly invested, they will gain greater and greater returns and will end up increasing their total wealth over the course of their career. [DISCUSS CHANGE FROM HUMAN TO FINANCIAL CAP]
Here we can see that around retirement age, one’s human capital should be completely expended, and they can – well, retire! The accumulation stage ends and the retirement stage of one’s life begins.
And one final illustration to emphasize the fact that our models seek to transform your human capital into financial capital over the course of your lifetime. It’s not a matter of a one time investment that will change your financial future forever – these things require constant management.
Alright, so how does human capital fit in with the rest of my asset allocation? That’s what is most important. If we’re seeking to improve Harry Markowitz’ work with the Efficient Frontier, we’ll have to plug the improvements in at sometime – so here we go. As we age, our asset allocation changes, or rather adapts to match our personal aversion to risk. In this graph, we’re looking at the same calculations from Ibbotson and associates from before, where they examine someone with a slightly above average aversion to risk (probably a common standpoint for many in today’s economy). As we age, we need to transfer our financial capital from high risk assets into low risk ones – standard MPT. But the next question is, how do I determine the riskiness of my human capital?
Here’s a pretty simple way. Based on your job type and your job security.
So back to this graph from before – if my human capital is relatively risk free, well then I’m not going to have to switch some investments over to risk free assets at the age of 37, because whether I like it or not, I’ve had risk free assets since I started working anyways. This is a prime example of where human capital fits into this capital asset pricing model in a way that Markowitz never thought possible. I can’t lie, right around now I myself would be wondering, “okay that all sounds great, but in the same way that Markowitz’ model hinged on a correct valuation of risks, all this hinges on a correct valuation of human capital. How do you do that?”
The next couple of slides will display some of the mathematical equations we use, I’ll give a brief overview of the math and how it applies to what we are trying to do. Each successive equation is dependent upon the results of the previous, and in the end, their dependency looks like this. This chain of dependency will stay on the right side of the screen to give you an idea of what we’re doing, and where we’re going with it. [CLICK] This is the math we use to calculate your human capital. It takes into account factors such as your age, life expectancy, earnings, and interest. Once we’ve calculated your human capital to a high degree of probability, we can optimize your asset allocation.
And, this is how we do that. In order to determine your optimal asset allocation, we calculate your place on our revised version of Markowitz’ Efficient Frontier.
And finally, as we attempt to optimally manage your risks like wage earnings, mortality, job security, and longevity we can present you with an ideal life insurance policy or fixed (or variable) annuity plan. These calculations take into account all of the information we’ve recently calculated in addition to things such as your desired death benefit for your family and bequest motives, etc.
And here’s an illustration depicting your asset allocation taking into account such risk managing products as annuities.
Herbert Simon wrote a book called Models of Man in which he commented on how such rigorous mathematical systems can react when they are employed by emotional and sometimes less than rational human beings. [READ THE QUOTE AND ADMIT VULNERABILITIES]
