Is the client's risk profile more like a stock or a bond? The answer will help determine how to allocate a client's human capital and physical capital in the client's retirement portfolio.
So says Moshe Milevsky, a professor of finance at York University, Toronto, Ont., who spoke to Income Planning for this 5th anniversary issue of the newsletter.
"The greater your human capital, the more risk you can afford to take with your financial capital, nest egg or retirement plan," says Milevsky. "It becomes extraordinarily important as you get close to retirement and try to figure out how to generate an income in retirement.
Clients don't want to wake up at retirement age with no more human capital and realize that they didn't plan accordingly, he says.
Human capital, the projected value of one's of earnings over a period of years, declines as an individual approaches retirement, says Milevsky. An individual's physical capital–mutual funds, individual retirement accounts, rental income property, and other physical assets–become proportionately more important in tandem with this decline.
Early in the working years, a person's human capital classification is more like a stock than a bond, he continues. Therefore, the individual can take a more aggressive orientation to the invested portion of physical capital than would be prudent in later years, when human capital is diminished, and the individual's risk profile is more akin to a bond.
Key to deciding upon an appropriate portfolio allocation, says Milevsky, is one's occupation.
The human capital of people who work for investment banks or mutual fund companies have a high exposure to fluctuations in the financial services industry, for instance. Therefore, says the professor, they should compensate for this exposure by investing their physical capital, such as their 401(k)s and individual retirement accounts, in other sectors. If they invest in financial services companies, they would only be "duplicating" their exposure, since they're already employed in this sector, he explains.
The same principal applies for individuals employed in other fields, adds Milevsky. If a client is in the publishing business, that person should not invest in media companies.
If another client is an engineer or manager in a mining company, it would be prudent to build a diversified portfolio for this client that does not including precious metals, thereby mitigating exposure to this sector. "If commodity prices decline, the client would take a double-hit if you're both working and invested in the mining business," Milevsky explains. Again, don't duplicate, he says.
"When people ask, 'why shouldn't I double up on mining,' my response is, 'This is your retirement we're talking about,'" says Milevsky.
Advisors interviewed by Income Planning generally see value in Milevsky's conceptual framework when used to develop a wealth accumulation or income plan.
Larry McClanahan, a Clackamas, Ore.-based financial planner affiliated with KMS Financial Services, Inc., Seattle, Wash., notes that a person's capital classification (human to financial capital ratio) can help advisors estimate the "gap" between a client's existing financial capital and the amount needed to sustain a desired retirement lifestyle.
