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2013, Study Session # 4, Reading # 14

“LIFETIME FINANCIAL ADVICE: HUMAN CAPITAL,

ASSET ALLOCATION, AND INSURANCE”

MV = Mean Variance
HC = Human Capital

Traditional MV analysis does not consider many risks that individual investors
face throughout their lives.

Risk factors associated with HC include earnings, mortality & longevity risk.

These risks can be hedged through diversification, life insurance, & lifetime
payout annuity.

Life insurance can be a perfect hedge to mortality risk (correlation =-1).

Life time-payout annuity is used to hedge longevity risk.

1. HUMAN CAPITAL AND ASSET ALLOCATION ADVICE

Risk tolerance depends on psychological attitude & financial situation of an

individual.

HC ⇒ economic PV of an investors’ future labor income.

One must include HC in asset allocation decisions.

In early stage of life cycle, financial capital is used to hedge HC.

Optimal asset allocation depends on:

Risk-return characteristics of HC.

Flexibility of HC.

HC & Assets Allocation Modeling

HC can be calculated as:

(ℎ௧ )
௡

  = 
(1 + +
)௧ି௫
௧ୀ௫ାଵ
where
x = current age

 = human capital at age x
ℎ௧ = earning for year t (inflation adjusted)
n = life expectancy
r = inflation adjusted risk free rate
v = discount rate

HC is considered as a stock (bond) if highly (less) correlated with financial
market & more (less) volatile.

If HC is riskless ⇒ investor should invest more in stocks.

Equity-like HC ⇒ financial portfolio should be dominated by fixed income
assets.

Optimal allocation to the RF asset
with initial wealth.

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2013, Study Session # 4, Reading # 14

2. HUMAN CAPITAL, LIFE INSURANCE, AND ASSET ALLOCATION

The value of HC, the more life insurance the family demands.

The optimal level of insurance depends on:

The expected value of HC.

The risk-return characteristics of the insurance contract.

Investor’s objective is to maximize overall utility (alive state & dead state) by choosing
life insurance & making an allocation b/w risky &RF assets:
ఏೣఈೣ  1 − 1 − ௫ ௔௟௜௩௘ ௫ାଵ +
௫ାଵ  + ௫ ௗ௘௔ௗ ௫ାଵ + ௫ 
where:
௫ = amount of life insurance
௫ = allocation to the risky assets
D = relative strength of the utility of bequest
௫ = subjective probabilities of death (conditional on being alive)
௫ାଵ = wealth level at age x+1

௫ାଵ = human capital


The correlation b/w shocks to income & risky assets,  the HC & demand
for insurance.

Survival probability,
demand for life insurance.

More financial wealth, the less life insurance one demands.

As an investor ages, the demand for HC.

Conservative investors buy more life insurance.

3. RETIREMENT PORTFOLIO AND LONGEVITY RISK

Three Risk Factors in Retirement

Financial Market Risks Risk of Spending Uncertainty Longevity Risk

Cause portfolio value to fluctuate.
Inadequate savings to fund
Risk of live longer than planned for &

If market falls, the individual may be unable retirement portfolios. outliving one’s assets.
to maintain desired life style.
Can be minimized through save
Can be hedged away through:

Can be reduced by using modern portfolio more tomorrow (SMarT).
Longevity insurance provided by DB
theory. plans.

Life time annuities.

Personal savings are used to fund retirement income in two ways:

Systematic withdrawal strategy ⇒ receiving a lump sum, then
invests & withdrawal from the portfolio.

Annuitization ⇒ receiving a lump sum & purchasing a lifetime
annuity.

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2013, Study Session # 4, Reading # 14

Longevity Risk & Payout Annuities

Insurance product that converts an accumulated

investment into income.

Payout annuities are the opposite of life insurance.

Types of Payout Annuities

Fixed-Payout Annuity Variable Annuity

Fixed nominal $ amount each period.
Payments are variable & depend on the

Drawbacks: performance of underlying.

In the value of payments over time
Variable disbursements can be a potential
due because of inflation. drawback.

Not suitable for investors who prefer
liquidity.

If current IR is low, the investor would
be locked in these low rates.

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