[NEW YORK] WHAT is probably your most important asset? Stocks? Bonds? Real estate? Collectibles? None of the above. It is human capital. Although most of the focus in wealth planning is on financial assets, human capital is the one thing you can bring to the table that can have the most impact on your future. Yet few advisers stop to measure it fully and discuss its impact on your prosperity.
You have a surprising degree of control over your human capital, unlike the financial markets. You can switch jobs, obtain graduate degrees or simply work more as an independent contractor or partner in a professional firm. In contrast, you have no control over what stocks, bonds, commodities, real estate and other assets return every year. So consider human capital a measurable return on investment - in yourself.
The stodgy economist's definition of human capital is the net present value of lifetime earnings. This is what you will earn based on the skills, experience and talent you contribute to the labour market. For some, this is a fixed quantity, but in a dynamic world where people are increasingly shifting careers, working longer or pursuing "encore" careers, human capital is a moving target.
Yet estimating human capital is a bit like trying to guess your life expectancy. Life throws us a lot of curves and income gauges look easy to calculate as they emerge from a software programme. Nevertheless, you need to do some projections of lifetime earnings, and potential changes in your income stream, to make a realistic, flexible and holistic financial plan.
Zvi Bodie, a professor of finance at Boston University and co-author of Risk Less and Prosper (Wiley, 2012), says it is essential to know your human capital factor because it ties into how much risk you can take in your financial portfolio. Prof Bodie has been a pioneer in applying economic life-cycle theory to human capital decisions.
Some, with a fairly secure income over their career - such as college professors - may take more risk in their portfolios, while others whose income is linked to cyclical industries may not. You can characterise your human capital like a stable bond or an insecure stock. This is one of the first steps in linking your human capital to how much risk you may take in your portfolio.
"I see myself, for example, as a convertible bond," Prof Bodie said. "I'm protected by tenure at a solid university and have the potential to do extra things for income. I have a lot more capacity to take risk in my portfolio than I choose to use. I'm risk-averse, don't like to gamble and don't get a kick out of winning. I hate to lose."
Noting that "human capital is not a major asset for only a tiny fraction of the population", Prof Bodie said that lifetime earnings and portfolio management should be reframed as a way of insuring a standard of living and not a focus on obtaining the highest returns.
Figuring human capital into a prudent financial plan requires an attention to detail that most financial advisers may not be able to handle. Because most advisers are focused on managing money or picking investments, they may not be able to do the right calculations that are flexible enough to accommodate changes in income.
Paula Hogan, a fee-only certified financial planner based in Milwaukee, has been employing human capital and the life-cycle theory that underpins it into her business model for years. Like most planners, she carefully examines cash flow, expenses, income and her client's portfolio.
"A key insight of life-cycle theory," Ms Hogan said, "is that the consideration of human capital comes first and then portfolio management comes after that: financial capital is tailored to the human capital, not vice versa." Ms Hogan also steps into the realm of "life" planning that merges human capital with various goals and changes in a person's journey. This raises a set of questions that go beyond numbers. "What do you care about?" Ms Hogan said she asks clients. "Do you have a vision of where you want to be?"
If they want to change, the questions become more focused on transition. "How can we make a bridge? What about health insurance? Will you need a new family budget? Do you have family reserves (savings)? Is your spouse on board?"
Sometimes the transitions are modest, as for an executive at the top of his profession whom she counselled. He wanted to "not go at full tilt" and spend more time doing other things. Other, more radical moves, such as a career change, will require more support. Ms Hogan works with career coaches and counsellors such as Jane Schroeder of Brookfield, Wisconsin to manage the vocational piece.
As a master career counsellor and board-certified coach with a background in educational psychology, Ms Schroeder applies standard assessment tools such as the Myers-Briggs personality test and talks with clients on future direction. She delves into their core strengths, competencies, emotional intelligence and "brainstorms on possibilities".
"What allows you to engage your human capital at the highest level?" she asks clients. "When were you at your best? What was happening? What was energising?"
By re-engaging clients with the force that drives their ability to create, manage or earn money in a fulfilling way, Ms Schroeder eases the transition that some need to make.
It is one thing to know if you need to make a change, but is that possible, given your financial situation? Will you have enough cash reserves to see you through a transition? Will a spouse or partner support your household while you make some changes or re-educate yourself?
Before you even make the decision to redeploy your human capital, you will need to run some numbers to see if it is possible. Online planning programmes such as ES Planner (esplanner.com) can give you some general ideas on what is possible given changing income and cash flow.
While these questions may be difficult at first, they may help you forge a satisfying new path. But you will need to take your time and do some detailed planning that may involve a paradigm change.
Your personal capital reserve and future earnings should drive your ability to make a change and not your portfolio return. That is a big leap for most, but a rewarding one if you are able to navigate it. - NYT