We thought we’d take a moment this month and share with you a research project we’ve undertaken that we believe will benefit the unique population we serve in the D.C. Metro area. To that end, we’ve partnered with Dr. Mark Troutman, who knows this population well. He served in the U.S. Army for over 28 years before entering the academic sector as a business economist. Dr. Troutman’s comments:
When helping clients plan for retirement, we start the process by creating a cash flow statement and a net worth statement. Understanding income, expenses, assets, and liabilities helps us accurately forecast how much financial capital will be available in retirement, and answer the question most clients ask, “Will I have enough money to live on in retirement?”
The answer can be complex, but in simple terms the outcome is driven by variables you can control (e.g., your retirement date) and variables you cannot control (e.g., inflation). A shortfall typically means delaying retirement, spending less in retirement, or working part-time, often making the retirement planning process unsettling for some.
But there’s another aspect of planning that most clients and planners don’t ask. How will or can their human capital impact the financial capital in their retirement plan? Wikipedia defines human capital as the “stock of knowledge, habits, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.”
During my 28-year career helping individuals, affluent families, corporate executives, and entrepreneurs plan for retirement, I’ve come to realize that an individual’s own unique capabilities are his or her single greatest source of wealth creation. If deployed correctly, human capital can be a very powerful tool for creating financial capital. Quite frankly, it’s an aspect of planning that very few planners understand or take the time to discuss with their clients.
When evaluating human capital, the process is unique to each individual and their set of circumstances. Generally, there are two broad workforce groups – public and private – each with distinct human capital differences. We address both but this article will put greater emphasis on the public sector.
When advising private sector entrepreneurs, we analyze options for maximizing human capital that include strategies such as converting a “lifestyle business” into a business that has meaningful value at sale without the owner’s presence, growth strategies, or succession plans that position the company for acquisition as an exit for the owner. When advising corporate executives in the private sector, we analyze options for maximizing human capital that include obtaining equity in their company through stock options or direct stock ownership or perhaps creating a deferred comp (compensation) plan for key executives. Equity can generate substantial financial capital for retirement, while a deferred comp play can shelter income from taxes. If an executive’s employer is not willing to provide equity incentives or a deferred comp plan, we help clients evaluate the merits of changing employers.
Helping entrepreneurs and corporate executives think through these kinds of decisions may sound more like career planning or business coaching than financial planning, but we’ve found helping clients leverage their human capital can have a substantial impact on achieving their retirement goals.
Human capital planning takes on a different form for public sector clients. For this discussion, public sector employees include rank-and-file employees, managers and senior executive staff (SES) and elected officials, as well as enlisted military personnel and career officers – both active and retired. Our discussion would also apply to state and local government employees such as teachers, firefighters, and police officers.
In his book Are You a Stock or a Bond? Moshe Milevsky, a finance professor at the Schulich School of Business at York University in Toronto, points out that individuals with secure, stable income and employment (public sector employees) are like bonds, and can subsequently take more risk in their portfolios, while individuals with unpredictable income and employment (private sector) are more like stocks, and may require more conservative portfolios. By Milevsky’s measure, federal employment is a “bond” that converts human capital into stable and predictable income in the form of financial capital. In contrast, entrepreneurs, business owners, and corporate executives generally experience income that can fluctuate wildly with the economic business cycle. In essence, public and private sector employees should consider the predictability and the stability of their personal human capital when allocating their financial capital, i.e. making asset allocation decisions regarding stocks and bonds. The increased value of these unique aspects and their interaction is represented by the upward bend of the financial capital line in the graph shown below.
Lifecycle of Financial & Human Capital
This topic holds special interest for us as planners as the D.C. Metro area is distinct in many ways from other parts of the country. Looking beyond the constant traffic on the Beltway (itself an enemy of human and financial capital), D.C. is a culturally diverse population that offers top education institutions for all types of learning, access to the arts, science and history, and several professional sports teams to round out the list of available diversions.
But most of all, the D.C. area provides a strong, innovative, and highly-regarded entrepreneurial private sector that is complemented by a large public-sector workforce, namely the U.S. government and U.S. military forces. Most of us in this small town of over 6.0 million people are connected to, and benefit from, the federal government in one way or another – directly and indirectly.
The human capital characteristics of government and military employees allow for the implementation of unique investment and financial planning strategies for creating financial capital, when compared to those that typically apply to private entrepreneurs and executives. We see several distinct advantages that should be incorporated into financial capital calculations.
- STEADY AND PREDICTABLE INCOME: Federal sector employees typically enjoy steady and predictable income streams given the defined structure of “pay tables” and the defined aspects of government promotion systems. This structure provides the unique advantage of making accurate income projections over one’s career. While government pay systems are not guaranteed, they tend to rise each year in the form standard COLAs (cost of living adjustments), ensuring that incomes generally keep pace with inflation over time.
- EMPLOYEE BENEFITS: Federal employment pay packages include substantial benefits during employment, and more importantly during retirement. Notably, this includes generous healthcare coverage for government and military employees and a pension, we discuss below.
- UP OR OUT: Many aspects of employment in the federal sector have an “up or out” characteristic: Individuals must be on a career path to the top or move on and out. Those on the up path are growing their human capital skill assets earlier by comparison, creating incremental value in the form of private market second careers.
- DOUBLE DIPPING: Up or out provides federal employees the chance to “double dip,” i.e. retire and receive their annual pension and earn a second salary in the private sector. Second careers can span decades and the majority of second career salaries are typically saved and invested, creating additional financial capital. For active duty military personnel, eligibility for retirement benefits starts in earnest after twenty years of service, or roughly in mid-career, while retirement benefits for federal workers may begin at thirty years of service, or roughly their mid-fifties.
- SPECIALIZED TRAINING: Education opportunities provided as in-kind benefits offer the ability to develop new and specialized skills that can be applied in the private sector, post-transition. Many aspects of federal and military employment are specialized and otherwise hard to develop in the private sector, including top secret clearance.
- GUARANTEED RETIREMENT INCOME: Perhaps the greatest benefit to public sector employment is the retirement pension, which has a few unique characteristics itself: It’s guaranteed and tends to include a COLA, so it will generally go up. The guaranteed income derived from the pension is the equivalent of a “phantom” bond portfolio, as the income stream represents an underlying sum of money needed to generate the income. In many respects, a phantom bond portfolio is better than a real bond portfolio as there is zero risk of capital, investment, or interest rate. The downside is that you can’t access the capital in a phantom bond portfolio; there is no liquidity. However, a large phantom bond portfolio makes room for a higher stock allocation both before and during retirement, creating greater financial capital over time.
The unique aspects of military and government employment offer the ability to leverage both human and financial capital by increasing earnings, improving career opportunities, and leveraging embedded employee benefits before and during retirement.
In future articles, we will illustrate the dollar value that these human capital advantages can have on financial capital, and how we can put them to use for the unique population we serve – you!