Human Capital: Not Just Important for Asset Allocation

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Morningstar has conducted extensive research into the interplay between an individual's human capital--his earnings power over a lifetime--and financial capital. 

The CliffsNotes' version is that as an individual's human capital, or earnings power, diminishes with age, financial capital should grow to compensate. And as human capital declines and financial capital grows, the nature of that financial capital (that is, the investment portfolio) should also become more conservative because the individual will need to tap that capital for living expenses in retirement. That's the key reason asset allocations for early accumulators start out very equity-heavy but gradually shift into bonds and cash to provide liquid assets to meet living expenses during retirement. 

Morningstar's research has also suggested that those with volatile human capital--those who work in fields with high earnings volatility or a high potential for earnings disruption--should hold a more conservative asset mix than those with very steady earnings power. For example, it's only sensible that a commissioned stock broker or hedge fund manager--whose income is apt to be buffeted around by market winds--should hold more in cash and bonds than would a commissioned college professor. If lean income years arrive, the person with volatile human capital needs the cushion safer securities can provide. 

That's a very useful and intuitive finding. Less discussed, however, is the interplay between human capital and other parts of your financial plan: the size of your emergency fund, your insurance choices, and what investment wrappers you use, such as taxable, tax-deferred, or Roth. Human capital may have a role in all of those choices, too. 

Emergency Fund
Even casual students of personal finance have probably committed to memory the rule of thumb for emergency funds: three to six months’ worth of living expenses held in truly liquid investments, such as certificates of deposit and money market funds. But the nature of your human capital is a big swing factor when right-sizing your emergency fund. 

As you near retirement and your human capital declines, it stands to reason you should still have an emergency fund, even if your portfolio has grown substantially. True, you may have fewer fixed expenses; for example, your children may be grown or you may have your house paid off. It's also worth noting that a lower percentage of workers age 55 and older lost their jobs during the recent recession than was the case for younger age bands. That said, older workers who have lost their jobs have endured longer periods of unemployment compared with their younger counterparts, perhaps because people in the former cohort had higher-paying or more specialized careers. Moreover, there's a greater risk that older workers will encounter health problems, or their spouses will, and that could limit their ability to work as long as they wish.

In a related vein, those with more volatile human capital--even younger workers who, because of their professions, have high earnings volatility or run a high risk of income disruption--should consider holding a larger emergency fund than traditional rules of thumb might dictate. "Government workers probably would be OK with closer to three months in an emergency fund, while a hedge fund manager would need closer to a year in emergency expenses," says Morningstar head of retirement research David Blanchett. Sole proprietors and small-business owners whose income streams are highly volatile would also do well to hold a larger-than-average emergency fund. 

In addition to building out their emergency funds, individuals with dwindling or volatile human capital should line up next-line emergency reserves they could tap if, in a worst-case scenario, their emergency funds were depleted. Those next-line reserves might consist of short-term bonds held in a taxable or Roth account or a home equity line of credit. 

Insurance Needs
Human-capital considerations should also influence individuals' insurance choices in some situations. Although long-term disability insurance is advisable for workers of all ages, fewer older individuals purchase such insurance than their younger counterparts, according to research by Sun Life Financial. Older workers may be deterred by the fact that long-term disability insurance rates and underwriting standards are higher for them. But there's also a greater chance that older workers will need to rely on disability insurance during their working careers. After all, 90% of long-term disability claims are the result of illnesses like cancer and cardiovascular disease, and we're at greater risk of these illnesses as we age.  

Moreover, even though older workers may do without disability insurance as their nest eggs grow (just as they might choose to forgo an emergency fund), it's also worth noting that prematurely tapping a retirement plan will likely result in tax consequences and/or a change in a person's retirement date or the sustainability of the retirement plan. 

Furthermore, individuals with very volatile human capital may want to think twice about employing a high-deductible health-care plan unless they have very large health-savings account balances or emergency funds. The maximum out-of-pocket cost for high-deductible plans is more than $6,000 for singles and nearly $13,000 for families. Thus, if a costly medical condition happens to coincide with a disruption in an individual's income stream, that convergence could prove devastating without adequate backup funds. 

Account Types
Finally, an individual's human capital has implications for what types of accounts he prioritizes. Someone who has extremely stable human capital--that is, very little chance of income disruption during his lifetime--may safely hold a larger share of his portfolio in accounts that carry heavy taxes and/or penalties for pre-retirement withdrawals. Because such individuals bear little risk of prematurely tapping those accounts, they might reasonably emphasize tax-deferred accounts such as 401(k)s and Traditional IRAs, even though early withdrawals from such accounts can be costly: ordinary income tax plus a 10% penalty. 

By contrast, individuals with volatile earnings streams will want to emphasize account types that carry fewer strictures on premature withdrawals, such as Roth and taxable accounts. Money pulled from a taxable account will be taxed at the capital gains rate on any appreciation in the holdings, with the rate topping out at 20% for those in the very highest tax bracket and 0% for those at lower income levels. Meanwhile, Roth accounts are also reasonable choices for those who may need to tap their assets prematurely, as individuals can withdraw their contributions at any time and for any reason without triggering a tax bill or penalty. 

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