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.