Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance Flashcards
- a: Explain the concept and discuss the characteristics of “human capital” as a component of an investor’s total wealth.
- b: Discuss the earnings risk, mortality risk, and longevity risk associated with human capital and explain how these risks can be reduced by appropriate portfolio diversification, life insurance, and annuity products.
Human capital (HC) is the discounted present value of the individual’s projected future earnings.
Financial capital (FC) is the current market value of the individual’s portfolio assets.
Total wealth is the sum of HC and FC.
HC is subject to earnings risk as employment could cease
At retirement, the individual faces longevity risk of outliving his FC. This risk can be hedged with annuities.
An integrated investment model should:
• Consider the **size, volatility, and correlation to other asset of HC. **
• Jointly analyze life insurance, portfolio asset allocation, and HC.
• Consider annuities at retirement
An asset allocation model should consider not only the risk aversion and objectives of the individual but also the correlation of HC and FC in order to maximize the
individual’s utility.
13.c: Explain how asset allocation policy is influenced by the risk characteristics of human capital and the relative relationships of human capital,
financial capital, and total wealth.
13.g: Recommend basic strategies for asset allocation and risk reduction when given an investor profile of key inputs, including human capital, financial capital, stage of life cycle, bequest preferences, risk tolerance, and financial
wealth.
Scenario 2: A young investor with uncertain future income. Also the income is highly correlated with the economy and stock market making for risky, equity-like HC.
Financial capital (FC) is minimal. The HC should be treated as equity and the financial capital allocated to fixed income investments.
Scenario 3: A young investor with uncertain future income but the income is uncorrelated with the economy and stock market making for risky but non-equitylike HC. Financial capital (FC) is minimal. This investor will follow a path similar to Scenario 1.
13.d: Discuss how asset allocation and the appropriate level of life insurance are influenced by the joint consideration of human capital, financial capital, bequest preferences, risk tolerance, and financial wealth.
LOS 13.e: Discuss the financial market risk, longevity risk, and savings risk faced by investors in retirement and explain how these risks can be reduced
by appropriate portfolio diversification, insurance products, and savings
discipline.
Life insurance is the perfect vehicle to hedge this mortality risk,
** strong positive correlation of HC and FC reduces the need for life insurance**.The reasoning is that higher correlation means less diversification and higher overall risk.
Those with relatively more FC (meaning less HC) have less HC to insure and less need for life insurance.
As FC increases over time, the risk taken with the FC should be positively related to the riskiness of the HC. In other words, if the remaining HC is risky, invest more
FC in equity but if the remaining HC is lower risk, take less risk with the FC
- g: Recommend basic strategies for asset allocation and risk reduction when given an investor profile of key inputs, including human capital, financial capital, stage of life cycle, bequest preferences, risk tolerance, and financial
wealth. (Cont.)
Life insurance is highest initially to hedge mortality risk with the larger the portion of wealth coming from HC.
The insurance need declines as HC declines and FC rises
2 A -A mid-life investor -considerable FC and HC will have higher needs for life insurance, if the larger the bequest (post-death) objectives.
2 B The same mid-life investor’s assets will shift to lower risk FC assets if their aversion to risk is high and increase the holding of life insurance. More aggressive
investors would shift to higher risk assets and less life insurance.
2-D If there is a strong positive correlation
of FC and HC, this leads to a more conservative asset allocation and less need for life
insurance.
13.e: Discuss the financial market risk, longevity risk, and savings risk faced by investors in retirement and explain how these risks can be reduced by appropriate portfolio diversification, insurance products, and savings discipline. (Cont.)
LOS 13.f: Discuss the relative advantages of fixed and variable annuities as hedges against longevity risk.
LOS 13.g: Recommend basic strategies for asset allocation and risk reduction when given an investor profile of key inputs, including human capital, financial capital, stage of life cycle, bequest preferences, risk tolerance, and financial
wealth. (Cont.)
Financial risk is due to changes in financial market prices or conditions. The retired individual must continue to consider both short-run and long-run risk.
Longevity risk is the risk of outliving the FC assets, and it rises now that HC is zero.
Spending uncertainty risk is the simple inability to precisely predict how much will be needed during retirement or how long it will be needed.
the longevity risk can be hedged by combining lifetime annuities with the more traditional stock and bond portfolio.
A fixed annuity makes a constant nominal payment for life and leaves the beneficiary
exposed to declining real value over time, in other words, inflation risk.
