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; c explain how asset allocation policy is influenced by the risk characteristics of human capital and the relative relationships of human capital, financial capit
Human Capital
Economic Present value of the future labour income
Human capital should be incorporated while deciding on asset allocation and should be seen along with financial assets to diversify
“1) younger investors invest more in stocks than older investors; 2) investors with safe labor income (thus safe human capital) invest more of their financial portfolio in stocks; 3) investors with labor income that is highly correlated with the stock markets invest their financial assets in less risky assets; and 4) the ability to adjust labor supply (i.e., higher flexibility) increases an investor’s allocation to stocks.”
Life Insurance and Human Capital
Life insurance is a perfect hedge to human capital and has a 100% negative correlation
Mortality risk is considered in life insurance
“Investors need to make asset allocation decisions and life insurance decisions jointly.
■ The magnitude of human capital, its volatility, and its correlation with other assets significantly affect the two decisions over the life cycle.
■ Bequest preferences and a person’s subjective survival probability have significant effects on the person’s demand for insurance but little influence on the person’s optimal asset allocation.
■ Conservative investors should invest relatively more in risk-free assets and buy more life insurance.”
Retirement portfolio and longevity risk
Three risks confronted by investors when making saving and investment decisions
1. Financial MArket risk
2. Longevity Risk
3. The risk of not saving enough
Financial MArkets Risk
- if markets drop early in the retirement, the portfolio may not be able to provide the required income till the death of the investor.
Mitigation
Through modern portfolio theory
Longevity Risk
Risk of living longer than planned
Mitigation
Insurance products
Life time annuities
Risk of Spending uncertainity
Mitigation
Behaviourial issues
Longetivity
Social security n DB
- Covered risk
DC plAans
Born by individual
Two ways
Systematic withdrawal strategy
Annutization
Longevity Risk n Payout Annuities
“A lifetime-payout annuity is an insurance product that converts an accumulated investment into income that the insurance company pays out over the life of the investor. “
Two types
1. Fixed
- Erodes purchasing power
- Cannot be traded
2 Variable based on the performance of the underlying assets
Strategy
- Use a combination of Systematic withdrawal and Annuity to minimize the risk
