What is human capital and why could it be important for your retirement plan?
In the days of final salary pensions, retirement planning was pretty simple.
For each year you worked, your retirement pension would increase, and when your retirement pension was more than your expenditure, you were in a position to retire (in a perfect world!).
But most importantly, once you had earned your pension, it couldn’t reduce, so, as long as your outgoings didn’t go up faster than your pension, you could afford to retire.
Only a few of us have substantial final salary pensions as we approach retirement now, and this has had a big impact on retirement income planning.
With an investment linked pension, the amount of income you can have in retirement depends on the value of your pension fund (which can go down as well as up) and the percentage you can safely withdraw from it. Whilst the safe withdrawal percentage doesn’t change much, the value of your pension fund can be subject to large investment fluctuations.
Research tells us that we can counteract typical investment fluctuations by diversifying through cash, property, gilts etc, and by varying the safe withdrawal rate – for example, you can increase the initial withdrawal percentage when asset values are some way off their all-time high.
The fluctuations in value which we have experienced since the middle of 2018 are nothing unusual, and were dealt with by diversification and careful management of the initial withdrawal rate from your pension fund.
Many people worry how their retirement will be affected if we experience extraordinary market conditions again, like we did after the Tech Bubble burst in January 2000. Back then, shares lost 45% of their value and didn’t recover their original value for over 6 years.
Whilst your retirement savings should be diversified, it would be unusual not to have significant exposure to shares.
In the old world of final salary pensions and annuities, retirees took no investment risk – so pension fund managers and annuity companies were the only people who needed to worry about this sort of thing. But in today’s world of investment linked pensions, retirees need to think about this sort of thing before they give up work.
A large fall in the value of your retirement savings could move you down a level in terms of financial independence and this is, indirectly, what worries so many of us in the run up to retirement.
The good news is that there is a solution to this problem, but it isn’t the sort of solution that a pension or investment company can offer you.
When you work, your income is provided to you by what we call your “Human Capital” – your personal ability to earn a living.
In the traditional approach, you give up on your human capital when you reach your retirement age. No more work, and no need to keep your human capital ticking over in case you need to find work.
Human capital isn’t just your ability to do the job you were doing before you retired – it is made up of your knowledge, experience, social and personality attributes which give you the ability to earn a living.
In the world of investment linked pensions, one solution to the risk of sudden or protracted fluctuations in the value of your retirement savings at retirement is not to give up on your human capital completely.
We find increasingly that our clients are reducing the amount that they work at conventional retirement age, or doing something quite – there has been an enormous increase in the number of self-employed over 50s and the buy to let boom can partly be explained by retirees using their human capital in a new way.
If you continue to nurture your human capital in the early years of retirement, you will retain an additional potential source of income.
Quite apart from the personal and social benefits you may derive from maintaining your human capital, it may provide some important protection against stockmarket fluctuations, allowing you to avoid taking money out of your portfolio at the wrong time.
Those of us who rely heavily on investments for our retirement income may well be able to retire sooner by continuing to nurture our knowledge, experience, and social and personal attributes in the early years of retirement.
Human capital isn’t discussed much in the world of retirement planning – perhaps it should be.