As a retirement plan advisory firm, we devote a significant amount of time to assisting plan sponsors in the selection and evaluation of tools participants use to develop long-term savings and investment strategies. While not a new tool, the concept of human capital as an asset class has come up in recent conversations. This asset class is not always explicitly addressed by providers in developing a participant’s strategy, but human capital plays an important role in the overall wealth planning process for each participant. Human capital, in this context, is defined as the present value of a participant’s future wages and it is a non-tradable asset. For early career participants, it's likely to be the most valuable asset they own. As time progresses, a participant’s human capital will diminish as it is converted into wages and, hopefully, invested into financial assets such as stocks, bonds, real estate, cash, etc. As an asset class, human capital offers inflation protection and has characteristics similar to bonds.
Participants that ‘own’ human capital can adjust their mix of financial assets from a portfolio perspective. For example, a young participant is likely to have a long working career and thus a large amount of human capital. As a general rule, this will allow the participant to allocate more of their financial capital to higher risk assets (i.e., stocks). The converse is true as well. Participants nearing retirement are likely to have traded their allocation to human capital in favor of financial asset classes. As human capital decreases as a percentage of total wealth, the participant’s ability to invest in risky assets is reduced which leads to a more conservative investment portfolio.
The use of human capital can provide more nuanced views of risk tolerance than the example described above. The predictability of a participant’s wages will further refine their optimal risk exposure in their retirement portfolio. If a participant works in an industry with high-income variability (i.e., construction), then this would argue for a lower risk portfolio. Another example of the use of human capital is expressed through portfolio diversification. A participant’s earning power is highly correlated to their chosen industry. The use of the human capital asset class would argue for lowering investment allocations to the participants’ specific industry in their financial asset portfolio.
As previously stated, incorporating human capital in the planning process is not universal in the defined contribution marketplace. Some providers have included the concept in their asset allocation process for target date funds or managed account products. Whether included or not, it’s a concept that I have seen help plan sponsors understand alternative providers’ approaches to developing asset allocation recommendations and risk tolerance determinations for various plan participant cohorts.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.