Download Understanding Human Capital

Understanding Human Capital
Benefits
3 Designed to pinpoint the most
appropriate asset allocation for
an investor
3 Offers a more objective
assessment of risk capacity
than questionnaires
3 Considers a person’s ability to
earn and save through retirement
3 Provides a more complete picture
of an investor’s financial worth
When financial advisers and online advice programs
construct an asset allocation for an investor’s retirement
portfolio, most will consider a range for factors, from
the client’s time horizon and risk-tolerance preferences,
to their financial holdings—stocks, mutual funds, real
estate, and other assets. This method, however, may not
result in the most appropriate portfolio for every investor.
market values, and, as such, should have the best risk and
return characteristics for every investor.
When determining how close investors are to the market
portfolio, you need to look at their entire wealth, which
includes both their current financial assets and their human
capital. Once you’ve made that determination, you can
ascertain how over- or under-exposed they are to equities.
From there, you may need to adjust their retirement
portfolio so their overall asset allocation is more closely
aligned with the market portfolio. How much of an
adjustment you make can depend greatly on the size of
the person’s human capital.
That’s because many traditional asset allocation
methodologies don’t consider a person’s human capital, a
predominately fixed income-like asset that reflects the
person’s ability to earn and save throughout their lives.
Depending on the person’s line of work, human capital—
which comprises such things as future wages, Social
Security, and pension benefits—tends to mirror fixed
income because its profile is similar to an inflationadjusted, real-return bond. Because younger investors
typically have a longer time to work and have had little time
to accumulate wealth, human capital is often their
largest asset. As such, when it is considered as part of the
asset allocation equation, human capital can alter the
makeup of an investor’s retirement portfolio dramatically.
Generally, younger investors have little financial capital
and a lot of human capital. As a result, when you calculate
how close these investors are to the market portfolio, you
may find that they are overexposed to bonds (remember,
human capital often has a bond-like profile). Consequently,
they may need a larger allocation to equities in their
retirement portfolio to nudge them back to the market
portfolio. The opposite is usually true for older investors,
who hopefully have converted a significant portion of
their human capital into financial capital. Additionally,
unless they have a pension, they may have exhausted much
of their human capital as they glide into retirement. As a
result, they most likely will need more bond exposure
in their retirement portfolio to offset their greater exposure
to financial capital, which has a more equity-like profile.
A Smarter Approach
When using human capital to construct an investor’s asset
allocation, you first need to determine their overall asset
allocation and then see how close it is to the market
portfolio, which is considered the “ideal portfolio” under
Model Portfolio Theory. This theoretical portfolio contains
every available security in amounts proportional to their
Building the Optimal
Retirement Portfolio
Ideally, the asset allocation of an
investor’s combined wealth (human
capital, financial capital, and
retirement portfolio) should mirror
the market portfolio.
Human Capital
Financial Capital
(non-advisable)
(non-advisable)
30%
stock 70%
bond
+
60% 40%
stock bond
Retirement Portfolio
(advisable)
+
55%
stock
45%
bond
Market Portfolio
=
46%
stock
For Illustrative Purposes Only.
Value: $200,000
Value: $155,000
Value: $100,000
Step 1
Step 2
Step 3
First, we model the
investment-like characteristics
of human capital as 30%
stock and 70% bond.
The value is based on the
investor’s age, gender,
income, savings rate,
pension, and Social Security.
Then we determine the
value of the investor’s
financial assets, and the
overall investment style
of those assets.
We can now tell how close
they are to the market
portfolio. If they are off
target, we will use the
retirement portfolio to try
to nudge their asset
allocation into alignment.
Value: $455,000
54%
bond
Understanding Human Capital
Serving the Workplace Market
Morningstar, Inc’s mission is to help investors reach their
financial goals. We were founded on the simple idea
that when people have good investment information, they
make better choices that lead to better outcomes.
Our advocacy for the individual investor extends to the
workplace market, where the responsibility for investing
and saving for retirement now rests with employees
and where we’re committed to helping those employees
achieve financial freedom.
It isn’t always this cut-and-dried. For instance, you
may have an investor who is close to retirement
with a significant pension benefit and outside assets
that are heavily invested in fixed income. As a result,
that person may need more equity exposure in their
retirement portfolio to offset the fixed-income
holdings. The graphic below shows how our portfolio
construction process can accommodate an investor’s
unique financial and human capital profile.
Human Capital Benefits
There are two main benefits of using human capital in the
asset allocation equation. First, we believe it results in
more accurate asset allocation assignments and reduces
the reliance on more subjective measures for gauging risk
tolerance, such as questionnaires. These questionnaires
can be confusing to some investors and can result in very
different results depending on what is going on in the
markets when the investor fills it out and whose
questionnaire they are answering. Second, human capital
helps investors see a more comprehensive picture of their
financial worth, which can help eliminate some of the
behaviors (such as panicking during market downturns)
that can hijack even the best-laid investment plans.
Human Capital in Practice
Investor A
Investor A is a physician who starts
her career with significant earnings
potential (human capital) but little
financial capital. As such, her
retirement portfolio initially requires
a high exposure to stocks to offset
her bond-like human capital. This
quickly changes as she converts that
human capital into financial capital.
Investor B
This investor is a factory worker
who doesn’t accumulate as much
financial capital as Investor A, but has
a large pension (human capital).
As such he needs a greater allocation
to stocks through his working years
than Investor A.
*”Morningstar” refers to Morningstar, Inc. and its affiliates. All investment advisory services
described herein are provided by Morningstar Investment Management LLC.
**Data as of 9/30/2015.
Retirement Age
$$$$
$$$
Human Capital Value
$$
$
Age
45
Financial Capital Value
65
85
Retirement Portfolio Allocation
% Stock
% Bond
Retirement Age
$$$$
$$$
Human Capital Value
$$
$
For Illustrative Purposes Only.
Morningstar* helps people improve their financial health
and prepare for retirement by offering financial wellness,
investment advice and managed accounts, targetdate solutions, and fiduciary services to plan providers and
employers. Available to more than 25 million participants
and more than 300,000 plans,** our suite of offerings
is supported by our database of more than half a million
investments, independent research that informs
and shapes the financial industry, and a valuation-based
approach to investment management.
Age
45
Financial Capital Value
65
85
Retirement Portfolio Allocation
% Stock
% Bond
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