Human Capital

The PV of the individual’s expected income from salary, bonuses etc., including the social benefits and pension funds as they are derived from works.

The numerators are the expected cash flows.

The denominator is risk-free rate + premium taking the volatility into account.

PV(t) = Sum(t+1,n) CFi/(r+risk premium)^(i-t)

Can have +ve human capital at retirement.

Financial Capital: saving and investment and life insurance

Accumulation Phase: from finishing career preparation to retirement is:

Human capital decreases

Financial capital increases

Earning Risk:

Unemployed, disabled, layoff

1. Increase saving rate – shift financial capital curve up
2. Reduce correlation between human and financial capital
3. If earning risk is low, can expose to higher risk in investment (offsetting risk in human capital with financial capital)

Mortality Risk:

Unexpected loss of human capital due to premature death, so less-than-expected financial capital left.

Hedge: life insurance

Life-time payout annuity

Immediate (single life, straight life, non-refund) annuity: Let you convert a lump sum asset to receive annuity payments. ceases when death, or continue on beneficiaries (can be lump sum) or joint.

Can be fixed (based on fixed interest rate) or variable (based on underlying asset)

Deferred annuity: like 401k but can be in lump sum or annuity

This can be used to hedge longevity risk.

Portfolio Allocation

Some human capital can be considered as bond-like (low risk low return)

Some are equity like (high risk, high return)

Human capital has size (young people has large size), correlation with other asset and risk (financial analyst has high return and high risk).