The Impact Of Human Capital On Retirement Savings

by: S&P Dow Jones Indices

By Zvi Bodie

This week I am participating in a retirement panel at the University of Chicago Booth School of Business with key thought leaders from the Plan Sponsor Council of America, the Employee Benefits Research Institute and S&P Dow Jones Indices. The panel, moderated by my good friend Jody Strakosch, creator of one of the first DC retirement income products, will focus on applying goals-based investing to default investments in DC plans.

In this blog, I discuss my thoughts on the impact of one’s human capital—the present value of lifetime earnings—on retirement plan design. Bob Merton, Bill Samuelson, and I were the first theorists to rigorously model this factor in our 1992 paper entitled Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model, (Journal of Economic Dynamics and Control, 1992). That paper influenced all subsequent theoretical and practical discussions on the topic.

The key insights were the following: First, the ultimate objective is to save enough during one’s working years to maintain a standard of living in old age after human capital is exhausted. Second, the optimal fraction of one’s retirement portfolio allocated to equities depends on the amount of remaining human capital (age) and equity exposure through one’s job. For example, the human capital for a tenured professor is less risky than that of a worker in a cyclical industry. The ability to adjust one’s age of retirement is a key factor in the optimal allocation to equities during the working years. In general, the greater the market-risk exposure of one’s job, the lower the fraction to invest in equities.

Since default investments tend to be designed for all workers during all phases of retirement planning we must seek to accumulate enough retirement assets and manage market risk exposure to achieve a target level of income in retirement. When we are young, say right out of college, most of us have a small amount of financial capital (potentially negative if we still have education debt); however, over time we gain financial capital by saving as we enter our peak earning years. Therefore, based on this assumption, lifecycle asset allocation should evolve over time, potentially from a high allocation to equities to a portfolio that produces a reliable stream of inflation-proof income.

For more on this subject, I recommend other blogs addressing retirement income, such as the recent post by my fellow panelist, Jodie Gunzberg of S&P Dow Jones Indices. If we adopt the mantra that income is the outcome, goals-based investing is the investment approach that helps our industry design the right default solutions for all workers, at all times.

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