An often overlooked element to lifetime financial planning is the value of human capital. It can be an ephemeral concept, but if analyzed properly has a discrete value that depends on some basic assumptions. In an interview with CNNMoney.com, retirement expert Moshe A. Milevsky (associate professor at York University’s business school in Toronto) illustrates the importance of considering your future earning power in the labor market in addition to traditional financial assets. We are often better off than we realize, but that’s only if we efficiently translate human capital potential to tangible future value.
Most of us who are young have few financial assets. We simply have not yet had the time to acquire them. What we have an abundance of is future earning potential. Milevsky urges us to consider this in the financial sense, as an asset; specifically, he likens future earnings to an annuity or bond.
Using the basic tools of discounting cash flows we can value the bond and get a rough estimate for how much our future earnings are worth today. The human capital spreadsheet shows you how to calculate these figures for yourself, and enables you to change any of the input assumptions to tailor to your own scenario.
If we assume you start your career earning a $50K salary, which grows at 4% per year, you have 40 years to work before retiring, and you discount the cash flows at 8% (rough average long-term equity rate of return), the present value of those future earnings is $1,052,000!
Prudence in career development can significantly enhance the value of your human capital bond. Changing the starting salary to $75K and the annual growth rate to 5% yields a PV of $1,825,000. What this really means is that you need to take your career into your own hands. Determine how educational investment can best yield favorable returns, continuously develop your skillset to increase labor market value, and always remember what you’re really worth!
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That arrangement was once (and still is for those that have them) the hallmark of the pension plan. Imagine those savings, done for you by a company that values what you have to offer and rewards you for their exploitation of your “human capital” with retirement benefits. It just sounds so antiquated.
And in this day and age, pensions are the ultimate retirement stabilizer.
Now imagine, as many employers do, participating in a 401(k) or having a Roth IRA outside the plan.
I wasn’t referring to any sort of pension plans, just the notion of thinking of your value in the labor market as a bond or annuity. As far as retirement preprations go, I am a big fan of leaving decision-making at the individual level. I am not a fan of government retirement programs (Social Security), or even tax codes that encourage employer-sponsored plans. And as far as employer-sponsored retirement goes, I am absolutely NOT a fan of defined-benefit plans. There are far too many demographic risks (people living far longer with far more expensive care options in old age) to make these plans economically feasible.
What it comes down to is that individuals must act like adults and live responsibly, portioning their resources over the course of their lives to moderate consumption. Defer now what is necessary to live on in the future. Of course this kind of planning becomes somewhat complicated, which is why we have professionals for hire who can do it for you. They are well worth the cost for most of the population.