Academic research shows that, over our lifecycle, we can generate income from three major sources: human capital, social capital and financial capital.
Chart 1 illustrates how these three capital sources of income combine to create unique client profiles that will also change over time.
From Median Income Thresholds to Personal Income StatementsLooking at overall population statistics in recent years, the Census Bureau has reported median annual household income around $44,334. Moving our focus to retirement, a 2005 Congressional Research Service report (Topics in Aging: Income and Poverty Among Older Americans in 2004, by Debra Whitman and Patrick Purcell) provides data suggesting median annual inflows into the personal income statements of current retirees (age 65 and above) were as follows:o Income from human capital --Wages: $15,000o Income from social capital --Private defined benefit plans: $6,720 --Public defined benefit plans: $15,600 --Social Security: $10,399o Income from financial capital --Annual income: $952
These numbers seem counterintuitive for most of us in the financial advice industry. Do we not expect our contribution to the investor's welfare to be proportionately larger than what these numbers show? Is the median annual income from financial capital really this small? Will this pattern -- representing the prior generation -- hold true of the baby boomers?
Medians and means (both measures of a "central tendency") can be misleading because the true distributions of income and wealth are most likely not symmetrical bell curves but highly skewed distributions such as the log-normal or even the power law distribution (also known as the "law of the vital few" and the 80/20 rule).
Chart 2 shows intuitively why the median of the symmetrical normal curve (half of the observations on one side of the median, the other half on the other side) overlaps the arithmetic mean (adding the value of the observations and dividing by the number of observations) and describes a representative situation, a common pattern illustrated by many measures of central tendency. This creates a business opportunity since we can define a large number of more-or-less similarly behaving customers.
It also shows clearly why the median and the mean of the asymmetrical log-normal, even more so for a power law, differ and represent threshold conditions. One does not have to get into the mathematics to see that averages in an asymmetrical distribution do not convey the same degree of the "typical investor behavior" that they convey in a symmetrical distribution. How do you optimize your practice for the average investor if your own investor income and wealth data follow such an asymmetrical distribution?
A normal distribution (bell curve) is the limit of what one would find by adding up the value of many independent quantities such as the height of people in a large group. A power law distribution is the limit of what one would find by multiplying the value of many independent quantities such as the relative size of forest fires over a large enough area and a long enough period of time.
According to Chris Anderson of The Long Tail fame, this multiplicative impact seems to be related to a networking effect. Power law distributions seem to be created by "preferential attachments" among nodes in "scale-free" networks, which is to say that the winners are more connected than the losers. Similarly, there seems to be a clear relationship between connectedness, income and wealth. We can all optimize our practice by directing and optimizing our connections.
Personal Income StatementsCan personal income statement planning improve your ability to connect with the right type of investor clients? Extensive personal-income statement planning approaches do not seem to be frequently used in the total returns-driven asset allocation and advisory process. Looking at the difference between the retiree's and the employee's personal income statement, we can understand why this is the case since more sources of income, as summarized in Chart 3, become more relevant for more investors as they move from employment and into retirement.
Given these generic sources of income available over our lifecycle, in what ways is a retiree's personal income statement different from an employee's?
During Employment YearsAs an employee, most of us are used to seeing a major and often single source of inflows in our personal income statement: employment income in the form of W-2 wages arising from the steady growth and eventual depletion of our human capital.
The self-employed will see human capital inflows in the form of 1099 income. They may also see inflows from business investments in the form of rental income, royalty income, etc.
Most employees will not see much income from social capital. While there may be the occasional gift or inheritance, Social Security and defined benefit pensions only begin to pay monthly income after retirement. On the other hand, those of us with medical and/or disability conditions may see income from matching social or insurance programs prior to retirement.
During our employment years, we are also in the accumulation phase with regards to our financial capital. During the accumulation phase, we convert what we save from our human capital inflows into financial capital.
If we invest this financial capital well enough and do not lose it or spend it all along the way, it may even grow at a compound rate that matches or exceeds inflation and taxes. Most of us reinvest inflows from financial capital during the accumulation years. Our investment vehicles tend to be geared for total return and capital gains instead of monthly income generation.
During Retirement YearsThis state of affairs changes with retirement. A retiree's sources of income may become more diverse and include inflows not only from human capital but also from financial capital and from social capital.
As a generalization, we can assume that during retirement, human capital is likely to exist but that it is dwindling. Ideally, liabilities where human capital is the real collateral (such as a mortgage since it is based primarily on your ability to repay the loan) should become smaller faster than the dwindling human capital.
Liabilities from social obligations, such as funding children's education, should also become smaller and the matching assets similarly spent.
The key liability that remains, as human capital dwindles, should be funding one's retirement income. Given the blended retirement pattern discussed in this column last March, we can expect that some retirees will start spending their financial capital and others will keep building it, at least for a while. Do you know how your investor clients plan to blend remaining human capital with their (hopefully growing) financial capital and social capital to meet their remaining (and, one hopes, limited to retirement income) liabilities?
If you ask most people, social capital may not feel as strong or secure as it once did. Many people, especially younger people, do not expect to see a positive return on their Social Security contributions. Some do not expect to see anything at all from the Social Security Administration. The demographics of the system have changed from a past where many workers supported few retirees to a near future where existing workers cannot support the many retirees.
The number of workers covered by a defined contribution plan may have once reached one-half of all private workers. It is now around one-fifth and continues to fall.
Corporations do not feel that they can afford the unexpected volatility of the funding burden.
Finally, it may be the case that families are not as large or as strong as in prior generations. Many parents do not expect that their children will ever take care of them.
If social capital is expecting to benefit from a share of the human capital of others, there may not be enough "others" in future generations to contribute to the well being of the current generation. It is interesting to speculate about how much guaranteed income the economy can be expected to support at any given time and for what categories of people.
Financial capital is a measure of human capital -- time productively used, saved and invested by a person net of spending needs and habits. As discussed more fully in April, at or during retirement this financial capital can not only be invested in diversified risky assets but also in guaranteed income from insurance contracts, risk transfer and cash-flow matching hedges and the proper duration-matched risk-free assets. Interestingly, spending accumulated financial capital relieves one from using time productively. In essence, money buys free time. Money buys non-productive time. Do you know how much non-productive time your investor clients plan, or are able, to buy with their financial capital?
This brings us back to the baby boomers. Will the boomers display the same pattern since our current data represents the behavior of prior generations? Consensus opinion suggests they may not benefit from the same amount of social capital as the prior generation. However, there is evidence -- driven by the size of their demographic cohort -- to suggest that much of the existing pool of financial capital will be concentrated with the baby boomers.
Time will tell if these differences in endowments and expectations will change personal-income generation patterns. In the meantime, we are all making business decisions that come down on one side or the other of the question.
Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see www.riia-usa.org