Lifetime Financial Advice

Integrating Mortality Risky, Financial Risk and Longevity Risk in a Lifetime Financial Advice

A financial advice coming from a travel professional is uncommon and risky; but this one is based on sound principles so you can be rest assured. The framework for this ‘free ki advice’ is based on four parameters and an interplay between them – the level of financial wealth an individual possesses, the earning capacity of the individual in the future, the amount of insurance coverage required and the risk that an individual can assume with his current financial wealth.

We often consider financial capital to be the only wealth that we have. Our total wealth in fact comprises of our financial capital and human capital. Financial wealth is the total of all financial assets that we have accumulated including assets like real estates and share holdings in privately controlled businesses. Human capital is the present value of our anticipated earning over our remaining life time or in other words human capital is what we are expected to earn in our remaining working life. So the total wealth is financial plus human capital.

 

In the initial stages of our working life, we normally have very low financial capital and large human capital as we are expected to work for long and our earning capacity is likely to increase. Also as we earn and start accumulating financial capital (or converting human capital into financial capital) our financial capital increases and human capital decreases. As we retire our human capital is negligible, there may be some human capital left in the form of pension payments etc, otherwise the bulk of our total capital comprises of financial capital.

The next theme is the riskiness of both financial capital and human capital and how our investing decisions of financial wealth need to consider the effect of human capital.

A private investor basically faces three types of risks – i.e. mortality risk (or the risk of death and loss of income stream for the dependents), financial risk (risk of loss of value of financial assets due to market movements) and longevity risk (or outliving one’s financial assets). Mortality risk can be hedged with appropriate level of insurance (the universal life insurance policy) which is perfectly negatively correlated to the investor’s human capital. If one pays at the end of the year the other does not. If the insured is in the living state, the insurance expirers unclaimed and in the event of death, insurance coverage covers the loss of human capital (provided the full amount of human capital is insured). Thus mortality risk can be hedged away with appropriate insurance (and paying the premium).

 

The financial risk is the risk of fluctuations in the value of the financial assets due to movements in the market. The financial risk can be reduced by diversifying the financial assets and assuming less risk. The financial assets can be diversified by considering human capital as a part of the overall wealth (or total wealth). If the human capital is not risky (or employment is same and is not correlated with market movements) the investor can assume more risk with his financial capital or invest his financial assets aggressively in risky assets. The overall wealth will be more efficiently invested and the overall risk will come down.

The longevity risk or the risk of outliving one’s financial assets can be hedged with lifetime payout annuities which can either be fixed lifetime payout annuities and variable lifetime payout annuities. In fixed annuities the payment one receives over the risk of his life is fixed in nominal terms. Thus in fixed annuities inflation is not priced in and the real value of the annuity payments may fall in a high inflationary environment. In variable annuity payments are in the form of a fixed number of units of a particular fund. The value of the unit if derived by means of an NAV much like mutual funds or SIPs

 

Thus the take away from this reading is that hedge your human capital or what you are likely to earn in the rest of your life with adequate life insurance so that your dependents are not left unsecured in the unlikely event of death. Also hedge your human capital with adequate medical and disability insurance. Diversify your financial wealth by considering the riskiness of your human capital. For example a university teacher with less risky human capital should invest his financial wealth more aggressively in risky assets like equities and alternative assets. In comparison a stock broker whose income is tied up to the movements of equity markets has risky human capital and should thus invest less in risky assets and assume less risk by investing his financial assets in low risk investments like government bonds etc. Lastly, longevity risk needs to be hedged by purchasing a combination of fixed and variable lifetime annuity products. If the retirement corpus of an investor is large enough, the requirement of annuity products may not be required. But not all are lucky to have a large enough corpus at retirement. So plan for your retirement and plan in advance.