Financing Your Life

Calculating human capital to guide your financial decisions both before and during retirement

Vector Financial Advisors, LLC

“According to the Survey of Consumer Finances conducted by the U.S. Federal Reserve Board (2004), the number one reason for individual investors to save and invest is to fund spending in retirement…

…and significant changes in how individual investors finance their retirement spending have occurred in the past 20 years. Based on data from the Investment Company Institute, retirement assets reached $14.5 trillion in 2005. IRAs and DC plans total roughly half of that amount – which is a tremendous increase from 25 years ago.”

- Roger Ibbotson

Retirement Income In 2001

“The U.S. Social Security Administration reports that 44% of income for people age 65 and over came from Social Security income in 2001 and 25% from DB pensions. According to Employee Benefit Research Center reports, current retirees receive almost 70% of their retirement income from Social Security and traditional company pension plans whereas today’s workers can expect to have only about one-third of their retirement income funded by these sources (GAO 2003; EBRI 2000)…

Social Security

Savings Pension25% 31%

44%

Retirement Income In 2001

Social Security

Savings Pension25% 31%

44%

Retirement Income

Retirement Income Around 2010…Around 2020…

Social Security

Savings Pension25% 31%

44%

Retirement IncomeAround 2030…In 2001

Pension18%

SS16%

Savings66%

…The shift of retirement funding from professionally managed DBPs to personal savings vehicles [IRAs and DCPs] implies that investors need to make their own decisions about how to allocate retirement savings and what products should be used to generate income in retirement. This shift naturally creates a huge demand for professional investment advice throughout the investor’s life cycle.” – Roger Ibbotson

Retirement IncomeAround 2030…

Pension18%

SS16%

Savings66%

…The shift of retirement funding from professionally managed DBPs to personal savings vehicles [IRAs and DCPs] implies that investors need to make their own decisions about how to allocate retirement savings and what products should be used to generate income in retirement. This shift naturally creates a huge demand for professional investment advice throughout the investor’s life cycle.” – Roger Ibbotson

Retirement IncomeAround 2030…

Social Security

Savings Pension25% 31%

44%

2001 2030

Pension18%

SS16%

Savings66%

…The shift of retirement funding from professionally managed DBPs to personal savings vehicles [IRAs and DCPs] implies that investors need to make their own decisions about how to allocate retirement savings and what products should be used to generate income in retirement. This shift naturally creates a huge demand for professional investment advice throughout the investor’s life cycle.” – Roger Ibbotson

Social Security

Savings Pension25% 31%

44%

20302001

Savings

Pension

SS23%

21% 56%

Pension18%

SS16%

Savings66%

2030 Income Reduction

Ideal Retirement IncomeSavings reduced by 33%

22% Net Reduction

Savings

Pension

SS23%

21% 56%

Pension18%

SS16%

Savings66%

2030 Income Reduction

Ideal Retirement IncomeSavings reduced by 33%

22% Net Reduction

Greater Reduction

Savings reduced by 33%Pension reduced by 35%

28% Net Reduction

16%

22% 61%

Pension18%

SS16%

Savings66%

Personal SavingsAccumulated Labor Income

Defined Contribution Plan (commonly a 401k)

Individual Retirement Account (IRA)

Defined Contribution Plan (commonly a 401k)

Individual Retirement Account (IRA)

Professional Management

Since the mid-1950s

- Markowitz’ Mean-Variance

- Modern Portfolio Theory

- Maximum returns for your risk…

The method hinges on a correct calculation of one’s risk – but it does not take into account many risks that all investors will face throughout their lives.

Mean-Variance Framework‘Maximizing returns without risking too much’

0

2

4

6

8

10

12

0 2 4 6 8 10 12 14 16 18 20 22

Standard Deviation (Risk, %)

Exp

ecte

d R

etu

rn (

%)

Aggregate Bonds

Cash

Large Cap Stocks

Some Risks Not Considered

Longevity

MortalityWage Earnings

Job TypeJob Security

Is there an asset that these risks come from?

…and could it be incorporated into the mean-variance framework?

Human Capital

“Human capital is defined as the economic present value of an investor’s future labor income.”

- Roger G. Ibbotson

Converting Human Capital to Financial Capital

0

200

400

600

800

1000

1200

1400

25 30 35 40 45 50 55 60 65

Age (years)

Pres

ent V

alue

($)

Financial Capital

Human Capital

Total Wealth

0200400600800

100012001400

25 35 45 55 65 75 85 95

Age (years)

Pres

ent V

alue

($

Thou

sand

s)Converting Human Capital to Financial Capital

Accumulation Stage Retirement Stage

Ret

irem

ent

Converting Human Capital to Financial Capital

0

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40

60

80

100

25 30 35 40 45 50 55 60 65

Age (years)

Shar

e (%

) Human Capital

Financial Capital

Asset Allocation

0

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40

60

80

100

25 30 35 40 45 50 55 60 65

Age (years)

Shar

e (%

)

(Slightly above average aversion to risk)

High Risk Assets

Low Risk Assets

Job Type

Not Tied to Stock Market Tied to Stock Market

Job Security

Low Human Capital RELATIVE RISK

Human Capital HIGH RISK

High

Human Capital LOW RISK

Human CapitalRELATIVE RISK

Asset Allocation

0

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40

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100

25 30 35 40 45 50 55 60 65

Age (years)

Shar

e (%

)

(Slightly above average aversion to risk)

High Risk Assets

Low Risk Assets

Calculating Your Human

Capital

Optimizing Your Asset Allocation

Dynamically Managing Your Risks

Dependency of CalculationsCalculating Human Capital

∑+=

−++=

n

xtxt

t

vr

hExHC

1 )1(

][)(

x = Current age

HC(x) = Human capital at age x

ht = Earnings for year t adjusted for inflation before and after retirement, adjusted for Social Security and pension payments

n = Life expectancy

r = Inflation-adjusted risk-free rate

v = Discount rate (adjusted to risk level of income)

Calculating Your Human

Capital

Human Capital & Asset Allocation

)]([max 11)(

++ + xx HWUExα

Maximum percentage of assets allocated to risky holdings is

αx = Allocation to the risky asset

Wt = Financial capital at time t

Ht = Human capital at time t

Optimizing Your Asset Allocation

Dynamically Managing Your Risks

Calculating Your Human

Capital

Optimizing Your Asset Allocation

)]()()()1)(1[(max 111),(

xxdeadxxxalivex WUqDHWUqDExx

θαθ

+++−− +++

θx = Desired death benefit

αx = Optimized allocation to risky assets

D = Relative strength of the utility of bequest

qx = Objective probability of death at end of year x+1

qx = Subjective probability of death at end of year x+1

Wt = Financial wealth at time t

Ht = Human capital at time t

Ualive = Weight representing one’s ‘alive’ state

Udead = Weight representing one’s ‘dead’ state

Dynamically Managing Your Risks

Calculating Your Human

Capital

Optimizing Your Asset Allocation

Dynamically Managing Your Risks

Optimizing Life/Longevity Insurance

)]()()()1)(1[(max 111),(

xxdeadxxxalivex WUqDHWUqDExx

θαθ

+++−− +++

Dynamically Managing Your Risks

Calculating Your Human

Capital

Optimizing Your Asset Allocation

Dynamically Managing Your Risks

0

10

20

30

40

5060

70

80

90

100

1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0

Risk Aversion (CRRA)

Allo

catio

n (%

)

Immediate Variable AnnuityImmediate Fixed Annuity

Riskier Assets

Lower Risk Assets

Optimizing Life/Longevity Insurance

“I don’t care how big and fast computers are, they’re not as big and fast as the world.”

-Herbert Simon

Vector Financial Advisors, LLC

CPA, CFA is an Investment Advisor Representative. Securities and investment advisory services offered through Ameritas Investment Corp (AIC), member FINRA/SPIC. Vector Financial Advisors, LLC and AIC are not affiliated.

Representatives of AIC do not provide tax or legal advice. Please consult your tax advisor or attorney regarding your situation.