Reading 12 Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance Flashcards Preview

CFA Level 3 > Reading 12 Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance > Flashcards

Flashcards in Reading 12 Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance Deck (12)
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1
Q

Life expectancy

A

Life expectancy is only a measure of central tendency or a halfway point estimate. Almost by definition, half of all investors will exceed their life expectancy.

2
Q

What Is Human Capital?

A
  • Human capital is defined as the economic present value of an investor’s future labor income.
  • Human capital should be treated like any other asset class; it has its own risk and return properties and its own correlations with other financial asset classes.
  • Human capital can be calculated from the following equation:

HC(x)=∑t=x+1nE[ht]/(1+r+v)t−x

where

x = current age

HC(x) = human capital at age x

ht = earnings for year t adjusted for inflation before retirement and after retirement, adjusted for Social Security and pension payments

n = life expectancy

r = inflation-adjusted risk-free rate

v = discount rate

  • We assume the investor follows the constant relative risk aversion (CRRA) utility function.
  • In our case, it is

U=(Wt+1+Ht+1)1−γ/(1−γ)

for γ ≠ 1 and

U=ln(Wt+1+Ht+1)

for γ = 1. In Equations above, γ is the coefficient of relative risk aversion and is greater than zero.

3
Q

two basic types of risk for an investor’s human capital

A

There are two basic types of risk for an investor’s human capital.

  • The first type can be treated as risk related to other risky assets (such as stocks).
  • The second type is risk uncorrelated with the stock market.
4
Q

Implications of HC for Advisers

A

A financial adviser or consultant should be aware of the following issues when developing a long-term asset allocation plan for typical individual investors:

  1. Investors should invest financial assets in such a way as to diversify and balance out their human capital.
  2. A young investor with relatively safe human capital assets and greater flexibility of labor supply should invest more financial assets in risky assets, such as stocks, than an older investor should, perhaps even with leverage and debt. The portion of financial assets allocated to stocks should be reduced as the investor gets older. Also, if the stock market performs well, the investor’s financial capital will grow, and again, the implication is to reduce the portion of financial assets invested in stocks.
  3. An investor with human capital that has a high correlation with stock market risk should also reduce the allocation to risky assets in the financial portfolio and increase the allocation to assets that are less correlated with the stock market.

To effectively incorporate human capital into making the asset allocation decision, financial advisers and consultants need to determine:

1) whether the investor’s human capital is risk free or risky and
2) whether the risk is highly correlated with financial market risk.

  • In addition to the size of the investor’s human capital, its risk–return characteristics, its relationship to other financial assets, and the flexibility of the investor’s labor supply also have significant effects on how an investor should allocate financial assets. In general, a typical young investor would be well advised to hold an all-stock investment portfolio (perhaps even with leverage) because the investor can easily offset any disastrous returns in the short run by adjusting his or her future investment strategy, labor supply, consumption, and/or savings. As the investor becomes older, the proportion of human capital in total wealth becomes smaller; therefore, the financial portfolio should become less aggressive.
  • Although the typical US investor’s income is unlikely to be highly correlated with the aggregate stock market, many investors’ incomes may be highly correlated with a specific company’s market experience. Company executives, stockbrokers, and stock portfolio managers (whose labor income and human capital are highly correlated with risky assets) should have financial portfolios invested in assets that are little correlated with the stock market (e.g., bonds).
5
Q

Life Insurance and Asset Allocation Decisions

A
  • A unique aspect of an investor’s human capital is mortality risk—the family’s loss of human capital in the unfortunate event of the investor’s premature death.
  • The greater the value of the human capital, the more life insurance the family demands.

The model has several important implications:

  • First, it clearly shows that both asset allocation and life insurance decisions affect an investor’s overall utility; therefore, the decisions should be made jointly. The model also shows that human capital is the central factor. Although the decline in allocation to risky assets with increasing correlation may be intuitive from a portfolio theory perspective, we provide precise analytic guidance on how it should be implemented. Furthermore, and contrary to intuition, we show that a higher correlation with any given subindex brings about the second result—that is, reduces the demand for life insurance. The reason is that the higher the correlation, the higher the discount rate used to estimate human capital from future income. A higher discount rate implies a lower amount of human capital—thus, less insurance demand.
  • Second, the asset allocation decision affects well-being in both the live (consumption) state and the dead (bequest) state whereas the life insurance decision affects primarily the bequest state. Bequest preference is arguably the most important factor, other than human capital, in evaluating life insurance demand.
  • Another unique aspect of our model is the consideration of subjective survival probability
  • One of the widespread misunderstandings about insurance, especially among young students of finance, is that a person needs large amounts of life insurance only when facing the greatest chance of death (i.e., only for older people). To the contrary, the magnitude of loss of human capital at younger ages is far more important than the higher probability of death at older ages.
  • Asset allocation is primarily determined by risk tolerance, returns on the risk-free and risky assets, and human capital. The bequest motive has a strong effect on insurance demand but little effect on optimal asset allocation
  • Optimal insurance demand increases with risk aversion
  • Optimal allocation to the risk-free asset increases with initial wealth
  • Optimal insurance demand decreases with financial wealth
  • Life insurance is purchased to protect human capital for the family and loved ones. As the correlation between the risky asset and the income flow increases, the ex ante value of human capital to the surviving family decreases. This lower valuation on human capital induces a lower demand for insurance.
6
Q

Three Risk Factors in Retirement

A

A typical investor has two goals in retirement. The primary goal is to ensure a comfortable life style during retirement.

Second, they would like to leave some money behind as a bequest.

Three important risks confront individuals when they are making saving and investment decisions for their retirement portfolios:

1) financial market risk,
2) longevity risk, and
3) the risk of not saving enough (spending too much). Part of the third risk is the risk of inflation - earnings risk.

7
Q

Longevity Risk

A
  • Longevity risk is the risk of living longer than planned for and outliving one’s assets.
  • Life expectancy is only the average estimate. Roughly half of investors will live longer than life expectancy.
8
Q

Risk of Spending Uncertainty

A

Investors may not save enough to adequately fund their retirement portfolios.

9
Q

DC Plans and Other Personal Savings

A

A life annuity, whether received from an employer-sponsored pension plan or purchased directly through an insurance company, ensures that a retiree will not run out of income no matter how long he or she lives. If a retiree dies soon after purchasing an annuity, however, he or she will have received considerably less than the lump sum a systematic withdrawal strategy would provide. With payout annuities, the investor will also be unable to leave that asset as a bequest, and the income from the annuity may not be adequate to pay for unexpected large expenses.

10
Q

Longevity Risk and Payout Annuities

A

A lifetime-payout annuity is an insurance product that converts an accumulated investment into income that the insurance company pays out over the life of the investor. Payout annuities are the opposite of life insurance. Investors buy life insurance because they are afraid of dying too soon and leaving family and loved ones in financial need. They buy payout annuities because they are concerned about living too long and running out of assets during their lifetime. Insurance companies can provide this lifelong benefit by spreading the longevity risk over a large group of annuitants and making careful and conservative assumptions about the rate of return to be earned on their assets.

11
Q

Fixed-Payout Annuity

A

Despite the benefits of longevity insurance and fixed nominal payout amounts, a portfolio that consists solely of fixed lifetime annuities has several drawbacks.

  • First, as noted, is decline in the value of the payments over time because of inflation.
  • Second, one cannot trade out of the fixed-payout annuity once it has been purchased. This aspect may be a problem for investors who need or prefer liquidity.
  • Finally, when an investor buys a fixed annuity, the investor locks in payments based on the current interest rate environment.
12
Q

Variable-Payout Annuities

A

A variable-payout annuity is an insurance product that exchanges accumulated investment value for annuity units that the insurance company pays out over the lifetime of the investor. The annuity payments fluctuate in value depending on the investments held; therefore, disbursements also fluctuate.

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