---- — The financial life cycle model involves the process of managing two distinct but related assets that individuals have on their personal balance sheets. If managed properly, both can be used to fund a people’s liabilities (spending) throughout their lifetimes and help them reach their most important goals.
The first, known as financial capital, is one we are all familiar with. It represents the tangible wealth in the form of savings, investments, equity in real estate and other assets that we have accumulated and can use to fund consumption. In other words, these are assets that can be sold at any time and the proceeds spent. When planning for their futures, especially retirement, calculating, preserving, and growing financial capital is almost always the primary focus of individuals and their advisors. However, this limited view ignores an intangible but what is for most people a more significant asset, their human capital.
Economists define this second asset, human capital, as the present value (the worth in today’s dollars) of an individual’s stream of future lifetime earnings. Think of it as the value of a person’s expected after-tax future earnings. Human capital is affected by several factors, including the level and trajectory of earnings, taxes on the income and length of a person’s career.
Younger investors have far more human capital than financial capital because they have longer to work and save but have not yet had the opportunity to build their savings. For example, for people just entering the workforce, the value of their human capital is near a lifetime maximum because they have an entire career’s worth of earning years ahead, while financial capital is near zero or even negative if they have outstanding student or other personal loans. As they work and mature after-tax wages are allocated to spending, paying off liabilities and saving to increase net worth and financial capital.
Human capital continues to wind down as we approach the end of our working years. Older investors would therefore be expected to have less human and more financial capital because they have fewer years to work and save. Presumably, however, they have paid down liabilities such as mortgages and have built sizable nest eggs. Ultimately at retirement, when a substantial portion of retirees’ human capital is depleted, with the exception of Social Security and, for those fortunate enough to receive it, employer pensions or other continuing sources of retirement income, wealth is almost entirely financial. For those who have planned well and have accumulated sufficient financial capital, this can be a time to enjoy the fruits of their labors. For others who have not yet achieved this level of wealth, the option to work longer and save more is still available to them if they are willing and able to do so.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com .
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.