Where does human capital fit into the income plan?

Once this gap is estimated, he says, the human capital questions can be addressed. Among them: What’s the client’s current and anticipated earning power? And what risks are there to this earning power?

McClanahan agrees, too, that insurance has an important role to play in mitigating risks to the retirement plan.

“Unless the client is independently wealthy–in which case the human capital question may be moot–life, disability, medical, and eventually long term care insurance would typically be vehicles for addressing the most common risks to the human capital contribution needed to grow the financial capital pool,” says McClanahan.

“It follows that a retirement income plan that fails to identify and address these risks will likely be of limited value.”

But the human versus financial capital model has limitations, observe industry experts. Some clients have assets that don’t fit neatly into either financial capital or human capital classifications. For instance, McClanahan says these might include: current or future royalties on inventions, music, or publications; residuals on sales; or ongoing income from distribution rights.

McClanahan notes also that Milevsky’s capital classifications and the concept of a client’s “risk profile” presume an acceptance of modern portfolio theory, including the value of a strategic portfolio allocation. (Strategic portfolio allocation refers to setting target asset allocations and then rebalancing periodically or shifting as the client ages or situation changes).

While useful in identifying and managing risks to an income plan’s “gap” analysis, the capital classifications approach should not be extended to portfolio allocation, the financial planner says. The portfolio allocation should be “tactically” (not strategically) managed by “tilt[ing] portfolios toward opportunity and away from threats and thereby outperform markets over reasonable periods,” he says.

Adds Russell McAlmond, a certified financial planner and principal of Evergreen Capital Management, Portland, Ore.: “I would use the human capital part of the ratio for insurance analysis but not for portfolio planning.”

Good insurance planning can take care of the human capital considerations and determine how to replace that capital if something goes wrong, McAlmond says. “Life insurance, disability insurance, and other insurance policies can protect against the risk to human capital.”

Criticisms aside, Milevsky asserts that the capital classifications approach to retirement planning will eventually be broadly adopted. He foresees a time when most employers, for example, will filter out of their 401(k) plans companies that might otherwise add to plan participants’ risk exposure. He also envisions the development of mutual fund products, such as target date funds and lifecycle funds that mitigate investment duplication by customizing the portfolio allocation to an individual’s capital classification and risk profile.

The capital classification approach to retirement planning can also be valuable to advisors during initial discussions with prospective clients, says Milevsky.

“One tip I offer advisors is to get prospects to ponder how much of their financial capital they’d be willing to give up now to be younger–to trade in financial capital for human capital,” says Milevsky. “That can create a discussion around the value of this type of analysis.”