Human Capital Should Factor into Asset Allocation

April 22, 2014 (PLANSPONSOR.com) - Human capital is a key factor in asset allocation, says David Blanchett of Morningstar Investment Management.

In “No Portfolio is an Island,” Blanchett, head of retirement research at Morningstar Investment Management, says the key to asset allocation is a holistic approach. For an individual investor, it means factoring in more assets than simply the 401(k) plan—real estate, Social Security benefits, other pensions and assets, and the human capital of the individual.

Blanchett explains the concept of human capital as the accumulated wages of a lifetime, given earnings and skills. At age 25, he says, most people don’t have much financial wealth. Most of it will be earned over the next 40 years. “People don’t think of that,” he tells PLANSPONSOR, “But you can think of yourself as a stock. Every year, your dividend is your wages from human capital.”

Since age, health, education, occupation, industry and experience, among other factors, all affect human capital, it is a unique asset, Blanchett explains. “You can’t trade your human capital,” he says. “You can’t short it.” But it should be factored into the asset allocation of a portfolio because it is a definite, quantifiable asset to use in custom target-date fund allocations and glide paths.

“If you have risky human capital,” Blanchett says, “you should be more conservative in your portfolio, and vice versa.” The goal is to use human capital to get a truer sense of how to balance the other assets overall. Human capital is generally a safe asset, Blanchett says, and functions almost like a bond within a portfolio—factoring it in means a portfolio can handle more risk from greater exposure to equities.

Different professions and different jobs carry different amounts of risk, when they are being quantified in terms of human capital. Government agency jobs are quite safe, he says, as is the workforce of a university. Both have very safe human capital, Blanchett says. The glide path, then, for a target-date fund for one of these entities could be relatively aggressive because of this safety. “People effectively have a guaranteed job for a very long time,” he says, “so you can take on more risk in your glide path, because their human capital is relatively safe.”

However, Blanchett points out, these decisions can become somewhat more complex because people with safer human capital may personally prefer less risk. “You’re weighing two different things,” he says. “You can’t just use risk capacity. You have to balance it with risk tolerance.”

In the 401(k) plan for a hedge fund, Blanchett says, the plan sponsor must balance riskier human capital, people who may not be employed by the firm for a guaranteed long length of time. “You’d have to be more conservative in the glide path for the 401(k) plan,” he notes, “but these are risk-seeking individuals who would likely want to be more aggressive.”

Blanchett explains that human capital can tell a plan sponsor or investor directionally how to allocate.
“It’s a balancing act,” he says. The best way to think of human capital in asset allocation is that it should help shape the perspective of a portfolio. Blanchett says among the questions a plan sponsor should ask, when making investment decisions, is how risky is the human capital of its employees.

Morningstar’s research led it to assess different industries, based on a range of factors, to help assess the effect of human capital in a hypothetical portfolio. “How risky is it for different industries,” Blanchett says, meaning how it would affect asset allocation. “Government is the most bondlike,” he says, lending an effect of equities or risk in a portfolio of just 5%. More volatile industries, such as real estate, boost risk levels to as much as 40%. “Finance is 22%, utilities is 14% and manufacturing is 12%,” he says. The point is that different industries have different levels of risk for human capital.”

Plan sponsors should assess the risk preference of their participants, and also ask themselves what makes their company different. An off-the-shelf fund can work for some plans, but most companies have some distinguishing characteristics, Blanchett says, such as a pension benefit, or base of operations, or industry sector. “All these things that make you different should find their way into your asset allocation,” he says.

The concept might be easier for investment committee members and those with finance backgrounds, Blanchett says. In a recent meeting, several participants who are Chartered Financial Analysts (CFAs) easily grasped that certain factors can make a firm unique and should be factored into a custom target-date strategy.

Custom target-date funds are not new. Blanchett notes that a lot of 401(k) plans have them and will continue to add them. But, he contends, Morningstar has refined the methodology, turning up the focus on human capital.

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