We present a feature based on Joseph Stiglitz's recent presentation Uncertainties in the Life Cycle and How They Should Be Addressed.
Your biggest financial problem
Because:
• You don’t get a second chance to rectify errors you may make in investing for retirement
— Near impossible to re-build a retirement corpus
• You can’t rely on the experience of previous generations
— The defined pension system is on its way out; the investment environment is changing; life expectancy is rising
• You can’t even learn from others’ experience
— Lifestyle,income levels,family structure vary significantly
The missing piece in most portfolios
• Human capital is your most important asset (more than financial capital)
• Its returns are difficult to measure,as are its risks
• It’s non-tradable and,unlike financial capital,can not be diversified
• Its risk-return depends on occupation,education and age
• As you age,risk (uncertainty of return) from human capital decreases
Invest in stocks least when young, most when old
• Human capital risk (and reward) varies hugely across occupations
• Returns from human capital are least risky over time for government employees
• Risks could be greater for private sector workers,e ven more for self-employed
• Across all occupations,in varying degrees,human capital risk falls with age
• That means you can take greater risk with financial capital as you age
And what you aren’t asking
• Most advisers ignore human capital in financial planning
• They go by “thumb rules” or past returns or others’ experience—all of which can be misleading
• Add to that deliberate mis-selling to maximise commissions
• The combination of oversight regarding human capital and mis-selling of financial capital could play havoc with your finances,especially retirement planning
• The conventional advice to “cut exposure to equity as you age” makes as much sense when it’s reversed
...and miscellaneous learnings
• Housing, the second most important asset after human capital, often isn’t given the allocation it deserves
• Financial planning for the self-employed and part-employed needs to be even more distinct
• Retirement planning, thus, must also factor in the following:
— Age and education level
— Family structure and size
— Occupation (current and future)
• Human capital + financial capital = Complete Financial Planning
Zankhana Shah, Mumbai-based financial planner
Agreed that you don’t get a second chance to rectify investment errors and perhaps we are wrong in assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional has more reason to invest in equities than, say, a young entrepreneur in a start-up.These nuances are often ignored, even in our grander debates on how pension funds should be used in India.
My clients seek choice and good guidance. Choice is important because an individual knows more about his financial needs than anybody else. But, as Stiglitz pointed out, individuals make rational decisions by learning from experiences—their own and of others. That’s not possible always, especially for retirement planning.
Imagine someone commenting at 60: “I’ll do better next time” after realising he has not saved enough.At best there can be broad guidelines to tell you how to reach the desired goal; but the way one reaches the goal can’t be generalised as it varies across individuals.
As a planner, I have to address three needs—liquidity, regular income and growth. It’s like a tripod—all three are needed for a plan to stand steady. But in reality, all three move in different directions.
If the entire retirement corpus is put in a savings account, there is liquidity but no growth. If it is invested in stocks, there is growth but income may not be regular. Financial needs are unique and one can’t generalise them as based only on human and financial capital.
Jayant Pai, Mumbai-based financial planner
Individuals have two forms of capital—human and financial. Many of us who work to generate income are human capital. Simply put, human capital is the present value of one’s future labour income.
It accounts for predictable future income earned over one’s life cycle. The second form of capital is financial.This includes our savings and investments. Typically when we start our career, we start as human capital. Over a period of time we save and invest to create financial capital.
By this logic, when we retire we only have financial capital. So, in a sense, as long as we are employed, we remain human capital and the moment we cease to work we become dependent on our financial capital. Obviously, without human capital there is little room for financial capital.
But human capital is not only a mix of education, age and occupation.There is the human mind that can make an impact on the way human capital is exploited to create financial capital.
It is incorrect to say that most of human capital is usually more risky at a young age. Human capital depends on the individual’s skills and how it is tapped.
Agreed, you are just starting off on your career and the future is uncertain, but in today’s times there is nothing certain with careers, jobs and one’s ability to grow in a profession. It will also not be right to assume that with age human capital gets less risky.
B Srinivasan, Bangalore-based financial planner
Stiglitz’s assumptions that an individual has only two types of capital—relatively safe fixed-income bonds and equities that are more risky but which also give more returns—are flawed.
The question is how long-term savings should be distributed between the two as we age. Moreover, there are a whole lot of investment vehicles that mix and match both and need to be considered when devising a financial plan.As a practising financial planner, the first thing that I do is analyse an individual’s comfort with risk.
This determines the level of exposure the individual is willing to take in equity and debt and accordingly the plan is devised to meet the client’s goals. On retirement planning, Stiglitz is right to mention family structure and size, which works very well in the Indian context.
However, retirement planning is an important aspect that one should look at harnessing in one’s middle years (40s and 50s). By this stage, though there is a cost of starting out late, but a lot can be offset by your higher earnings and more disposable income.
You would have also met some of your financial goals and would have nothing more than retirement to look forward to.
