Paul Sullivan on Human Capital

WEALTH MATTERS

Learning How to Hedge Yourself, and Not Just Your Portfolio

By PAUL SULLIVAN

Published: March 5, 2010

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HOW much are your working years worth? Or put another way, what is the impact of joblessness on your financial future?

Ozier Muhammad/The New York Times

Michael Gordon, an executive at New York Life, says questions of risk apply to a person's earning potential, just as they do to his or her investments.

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With nearly 10 percent of Americans unemployed and investment portfolios still down from their peak, the value of work has been given new importance.

Economists have long debated the difference between human capital (your future earnings) and financial capital (your investments). But there has often been too little emphasis on human capital until it is too late.

“If the stock market goes down, would your income increase, decrease or not change?” asked Michael Gordon, first vice president for agency-life operations at New York Life Insurance. “If you’re doing bankruptcy consulting, it might increase. If you’re a stockbroker, it might decrease. If you’re a tenured professor, it might not change.”

This is the difference between financial capital, which would be affected regardless of your job, and human capital, which is linked to the health of your company and to the health of the industry it’s in. And while this discussion used to be an academic exercise, it is now a practical reality for many people.

A year after the stock market hit bottom, plenty of people are out of work and spending their retirement savings much sooner than they had planned. This was surely not part of any of their asset allocationstrategies.

Most people used to look at human capital only to imagine what would happen if they died or could no longer work. But now there is another way: what effect will losing your job have on your future financial well-being? Let’s look at both of them.

IF YOU DIE Typically, people buy life insurance when they have something to protect. They get married, for example, or they have children. But they often buy it arbitrarily — $1 million sounds like a lot to some people, but if they earn $150,000 a year, that is less than seven years of income. Now imagine if they died at 35 with two children. Their family would lose out on 30 years of earnings.

New York Life and Ibbotson Associates, an investment advisory firm, have developed a program to help people calculate the replacement cost of lost earnings. The intent is obviously to determine if someone should buy life insurance. But the process is more illustrative than that. The questions force the respondent to detail all the people and expenses he is responsible for and what he would leave uncovered without enough insurance.

In addition, the model calculates the volatility of a person’s earnings over his remaining work years. A tenured professor’s income would be far more stable than a stockbroker’s. If both were 30 and made $120,000 a year, the professor’s human capital would be valued at $2,270,000, while the stockbroker’s would be $2,110,000. They would rarely make the same amount, of course, but the professor’s replacement income is higher because of the stability of his job.

“Once I found out how much human capital you have, I have to find a way to hedge it,” Mr. Gordon said. “We wanted to find a way to answer that consistently.”

Put another way, the longer you work, the less the amount of earnings you have to insure. “As I age and work my way through my career, there’s less human capital to replace,” said Stephen Horan, head of private wealth at the CFA Institute, an association of investment professionals. “I would have converted much of it to financial capital.”

IF YOU LOSE YOUR JOB The notion of human capital has become more immediate in light of the high unemployment rate. The loss of your job is often not up to you. But you do have control over not allowing your job and investments to be correlated.

“People have learned in the last few years that their human capital is much more sensitive to the financial markets than they thought,” said Moshe Milevsky, a professor of business at York University in Toronto and the author of the book, “Are You a Stock or a Bond?” (FT Press, 2008).

The key is to make sure your human and financial capital are not correlated. Mr. Milevsky said he viewed himself as a bond, because as a tenured professor his salary did not fluctuate. So he can take on more risk in his investment portfolio.

But he pointed to a midlevel employee at Lehman Brothers as a stark example of a person who would have been a true stock: her earnings were tied to the company, which went bankrupt, and her investments were probably also tied up in Lehman Brothers stock.

This, obviously, is what you want to avoid: the perfect correlation between human and financial capital.

HUMAN CAPITAL IN PRACTICE Unlike financial capital, human capital cannot be monetized. You can sell all of your stocks and sit on the beach, but you cannot cash in the next 10 years of earnings. And that is why it needs to be well managed.

“Everyone has to make the assessment of how marketable their skill set is or how transferable,” Mr. Horan said. “My human capital is squarely tied to the financial industry. Other folks can span different industries, like a human resource person.”

This assessment is crucial to calculating your financial capital. Consider these two situations. A real estate developer would have his human capital linked to what he is building but also to the interest rates on the loans for those properties. Fluctuations in either one could affect his earnings. Excluding additional real estate and credit market risk from the developer’s portfolio would be smart, but Mr. Horan said the developer might want to go further and short an exchange-traded fund focused on real estate, betting, in other words, that its value would decline. “This would hedge the exposure that exists in your labor,” he said.

In the second example, Mr. Horan said a high-earning investment banker should have a conservative investment portfolio. “The value of his labor is going up and down very closely with fluctuations in the market,” he said. “And one of the reasons investment bankers get paid a lot is there is a lot of inherent risk — it’s feast or famine, and you’re at an organization’s beck and call.”

WHERE’S THE RISK? Proponents of counting human capital in any asset allocation like to differentiate it from discussions about risk. In fact, Mr. Milevsky goes so far as to say there is too much emphasis on a person’s risk tolerance.

“Before I have had my espresso in the morning, I’m more risk-adverse,” he said. “When I turn on CNBC and see the markets are up, I’m more risk-tolerant.”

But his point is a serious one. If you are young and have many working years ahead of you, your human capital is high, and you can take more financial risk. Just how much depends on the person. Are you comfortable taking that risk?

That is where the discussion of human capital is supposed to be less emotional. “Even very risky human capital is more bondlike than stocklike,” Mr. Gordon said. “The question is really, are you more like a junk bond or a Treasury?” Determining that could help you avoid the double whammy of losing both human and financial capital.