Individual investors face complex financial and investment decisions throughout their lives. The key to the whole process is to recognize that individuals have human capital as well as financial capital. This human capital contributes substantial earnings during the accumulation stage of a life cycle but should be at least partially protected with life insurance. As individuals age and save, human capital is converted into financial capital. As individuals invest, this financial capital grows to replace the future consumption needs of the investor. During the retirement stage of the life cycle, the income from the human capital needs to be replaced with pensions, Social Security, and the returns and principal from the financial capital. This article summarizes many of the ideas in the April 2007 CFA Institute Research Foundation monograph Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance.

The Accumulation Stage

This stage covers the working life and is typically from about ages 25 to 65. Individuals consume part of their income, saving the rest. Saving converts human capital into financial capital. The investor faces three main risks during these years: market risk, mortality risk, and savings risk. The market risk concerns what type of return the market will generate on financial capital. The mortality risk concerns the potential demise of the wage earner, with the corresponding ceasing of wage income for the family. The savings risk concerns the extent the individual and family are able to generate sufficient savings flow into their financial capital to adequately provide for the retirement stage of their lives.

Market risk is controlled by selecting an optimal asset allocation mix of the financial capital, in the context of individuals having part of their wealth in human capital. In our model, human capital is mostly fixed and bond-like. The optimal whole (human capital plus financial capital) portfolio can be selected while picking only the appropriate financial asset allocation mix. The human capital part can be protected with life insurance. The savings risk is controlled by solving for an appropriate savings rate.

Human capital is typically very large at the start of a career because it reflects the present value of all future income that individuals are expected to earn. Human capital also tends to be bond-like—that is, earning a relatively stable (although usually growing) predictable income stream. Most individuals have very little financial capital early in their career. This financial capital should be invested almost entirely in stock-like investments so that the overall asset allocation mix (including both human and financial capital) has a sufficient equity component. Young investors can also control market risk by exercising their option to adjust their working and savings plans if equity markets are weak.

As individuals progress through their careers, their human capital declines because less of it is available on a forward-looking basis. Ideally, they have saved some of this income so that it becomes available as part of their financial portfolio. As their financial capital becomes a greater proportion of their total wealth (human capital plus financial capital), the financial asset allocation begins to shift from almost all equities to a larger and larger proportion of bonds. By retirement, individuals usually hold most of their wealth as financial capital. Therefore, their asset allocation mixes should have sufficient bond allocations to reflect their desired mix of their total capital. In this way, the asset allocation of the overall portfolio (human capital and financial capital) remains relatively constant over the life cycle.

As the proportion of human capital declines with age, mortality risk, as it relates to the value of human capital, declines as well. Just as asset allocation mixes change over the life cycle, so too do insurance needs. During their early careers when individuals have large human capital, it is reasonable to protect much of this capital with life insurance. As individuals age, there is less human capital to protect, and less life insurance is needed. During retirement, there is little human capital left, but some life insurance might still be desired to insure that a minimum level of wealth can be transferred as a bequest.

During the accumulation stage, the actual asset allocation mixes and amount of life insurance to be purchased depend not only on age but also on the progression of individual careers. These decisions also depend on the amount of financial capital individuals have at any given time. The more financial capital individuals have, the less they need to buy life insurance to protect their human capital but the more they need to protect financial capital by making financial investments that are more conservative.

If individuals are especially risk averse, they will want to protect their human capital and their financial capital by both buying more life insurance and putting more bonds into their financial asset allocation mix.

It is worth noting that an individual’s profession affects his or her needs for life insurance and the asset allocation mixes. Individuals who work in low-risk (bond-like) professions (e.g., tenured teachers) especially need to protect their otherwise low-risk human capital by buying sufficient life insurance. Individuals who work in careers that have earnings that are highly correlated with the stock market or the economy (e.g., stockbrokers, commissioned sales people, etc.) should view their human capital as more stock-like and attempt to reduce their overall risk by holding more bonds in their financial portfolio.

The Retirement Stage

After individuals reach their retirement age, most of their human capital has been used up because they are no longer earning income on a regular basis. They may have a defined-benefit pension and Social Security benefits, and possible other sources of earned income, but likely much of their retirement consumption will have to be drawn from the principal and returns generated by their financial portfolios.

During this stage of their lives, retirees face three risks that are somewhat different from the three risks they faced in the accumulation stage. They still face market risk, likely at an even greater level than earlier because most of their capital is now financial capital. But they now also face longevity risk, which is the risk of outliving their assets. Finally, as they approach the end of their lives, they face a bequest risk, which is the risk that they may not be able to leave their desired amounts to their beneficiaries. They may have always have faced this last risk, but the probability of their having to make a bequest has gone up.

Individuals control market risk by choosing optimal financial asset allocation mixes. They can control longevity risk by purchasing immediate annuities, which pay out income each year for the rest of their lives. They can collectively manage the asset allocation mix to include stocks, bonds, as well as fixed and variable annuities. Finally, they can lock in any bequests that they want to insure by buying life insurance.

One way to meet retirement needs is to have saved sufficient amounts during the accumulation stage, investing the financial portfolio in stocks and bonds. Then when retirement income is needed, the investor can make systematic withdrawals from this portfolio. This procedure is likely to be successful if the investors live to their expected age as mortality tables predict. However, investors face longevity risk because roughly half of all investors (or couples, including spouses) live past their life expectancies. Thus, systematic withdrawals from stock and bond portfolios are likely to result in depleted financial portfolios for a large set of long-lived investors.

Longevity risk can be insured against by purchasing payout (immediate) annuities. Fixed-payout annuities pay a constant stream of income for as long as the retiree lives. The fixed annuity payout is usually expressed as a percentage of the amount of the annuity purchased. Variable-payout annuities pay out a variable stream of income over the life of the retiree based on the fluctuating value of an annuity portfolio so that in up markets, the payout increases.

An investor can assemble a combined portfolio of stocks, bonds, and fixed-payout and variable-payout annuities. This combined portfolio can increase the probability that an individual or couple will have sufficient yearly income to maintain their standard of living throughout their life span, no matter how long they live.

There is always a trade-off between insuring against longevity risk and the likelihood of leaving bequests to beneficiaries. As in the accumulation stage, investors can insure bequests by buying life insurance. We specifically try to match an individual’s trade-off between reducing longevity risk and meeting bequest desires. In general, payout annuity purchases reduce bequests but life insurance purchases protect bequests.

Although annuities reduce longevity risk, this benefit is diminished by waiting to purchase annuities because annuitizing early allows mortality credits to begin accumulating sooner. However, problems exist with early annuitization. The decision is irreversible and potentially costly. In addition, annuities reduce bequests and reduce control over one’s funds. We suggest waiting until after retirement to buy payout annuities and staggering the purchases.

Summary

We have suggested ways that investors can make stock, bond, life insurance, and payout annuity decisions over their life cycles. Individuals face a complex set of investment decisions that continually change throughout their life cycle. We believe that research has come a long way in addressing the practical problems that investors face. We hope that the concepts and financial models presented here can help investors meet their consumption, retirement, and bequest needs.

Roger G. Ibbotson is a professor at the Yale School of Management and chairman of Zebra Capital Management, a quantitative equity hedge fund manager.

Moshe A. Milevsky is an associate professor of finance at the Schulich School of Business, York University, and the executive director of the IFID Centre in Toronto.

Peng Chen, CFA, is president and chief investment officer at Ibbotson Associates, a registered investment adviser and wholly owned subsidiary of Morningstar, Inc.

Kevin X. Zhu is a senior research consultant at Ibbotson Associates, a Morningstar, Inc., company.