Should Market Risks Be Your Only Financial Concern?

The Financialist • Issue 98 • July 2008
BY KEN HAWLEY BComm FLMI CFP RFP CHFC

When investors experience a downturn in the stock markets or declining interest rate returns on their bonds and term deposits, they often focus on the short term volatility rather than the longer-term impact that their choices make on their financial well-being.

One of the ways to mitigate risk is through the appropriate asset allocation of your investment portfolio, which should include your “human capital value” as an asset category. I recently attended an advanced estate planning conference in Ottawa and one of the presentations was by Professor Moshe A. Milevsky, Ph.D. of York University, who is recognized as a world-renowned expert in the field of financial planning for retirement. In his presentation, he argued that an individual’s financial asset allocation, such as the mix of stocks and bonds in a portfolio, should be driven by the composition of our human capital (the risk and return characteristics of our career and job or pension benefits).

This is in contrast to the prevailing view that asset allocation should be based on time to retirement or risk tolerance, both of which can be fickle and mood dependent, often based on yesterday’s market movements.

Human capital is defined as the present value of an investor’s future income from their work, and although it is not readily tradable, it is often the single largest asset an investor has. As we enter the earning stage of our lives, our human capital is often at its highest point, but our financial capital is low. During our working career, we need to convert human capital to financial capital to prepare for the time when we enter the retirement stage of our lives, at which time our human capital may be almost depleted. Over the course of our retirement, we will gradually consume this financial capital and eventually bequeath any residual to our heirs or to charity.

Because human capital is often the largest asset an investor has, protecting it from potential risks such as (a) dying prematurely or (b) living too long, is critical to the development of a well-designed financial plan.

IMPACT OF MARKET RISK AND LONGEVITY RISK ON RETIREMENT INCOME

Investors must consider two important risk factors.

The first is financial market risk (i.e. volatility in the stock markets that causes portfolio values to fluctuate). If the market drops or corrections occur early during retirement, the portfolio may not be able to weather the added stress of systematic withdrawals necessary for living expenses. The portfolio may then be unable to provide the necessary income for the person’s desired lifestyle and remaining lifetime.

The second important risk factor is longevity risk – that is, the risk of outliving the portfolio. Life expectancies have been increasing, and retirees should be aware that they may live a lot longer than they expect – and plan accordingly to make sure they don’t outlive their income. This risk is faced by every investor, but especially by those taking advantage of early retirement, or those who have a family history of longevity. Increasingly, all retirees will need to balance income and expenditures over a longer period of time than in the past. While it is true that age 85 is roughly the life expectancy for a 65 year old individual, it is risky to assume that you will only live to the average life expectancy age.

There are several strategies for controlling longevity risk, such as including life annuities as part of the asset allocation mix or through the use of guaranteed variable annuities.
 

A long retirement also adds a further risk of the loss of purchasing power; this is often referred to as inflation risk. For example, at a 3% inflation rate, your purchasing power will be cut almost in half during a normal retirement period of about 20 years.

THE ROLE OF HUMAN CAPITAL IN ASSET ALLOCATION

Previous studies have indicated that one of the most crucial decisions in determining the success of long-term investment goals is the allocation among the traditional asset categories such as stocks, bonds, cash, real estate etc. in a portfolio. In the past, most advisors have ignored human capital, which is often the single largest asset an investor has on his or her personal balance sheet.

If asset allocation is indeed a critical determinant of investment and financial success, then given the large magnitude of human capital, one must include it. The construction of an optimal investment portfolio needs to consider many factors that are tailor-made for each individual’s unique circumstances and their stage of life.