Beyond the Balance Sheet: Valuing Human Capital

When clients think about their wealth, they often overlook one of the most significant contributors: the lifetime value of their career.

For many, the size of their paychecks tells them how much they can spend over the next few years. Most also have a sense that they need to save, although this understanding is clearer for some than others.

But there’s an opportunity to get clients to think of their career as a long-term asset. In many ways, managing a career is similar to owning a private business. You can invest in a career, derisk it, and drive long-term decisions based on its potential.

This shift in perspective can help clients better understand how their careers shape their long-term financial outcomes. It can lead to conversations about life insurance, planning for a risky career change, or scaling back lifestyle to support better work-life balance. Portfolios, reserves, insurance, budgeting, and more are all tools that an advisor can use to help address clients’ unique preferences and challenges.

To encourage this long-term thinking, it’s important for clients to see what their lifetime career earnings are worth today. Think of this number as analogous to the estimated market value of a private business.

It’s relatively straightforward to estimate this figure. The first step is to measure the value of a client’s lifetime earnings, called human capital. The next step is to incorporate human capital into a holistic picture of the client’s lifetime wealth.

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How to measure the value of human capital

Think of one of your clients and reflect on their wealth. It probably includes an investment portfolio, and maybe it also includes a home, real estate, alternative investments, equity compensation, or a private business, among other things.

Each of these assets has a market value that can be observed or estimated. By comparing market values, you can determine which assets are most important to the client’s overall financial success.

To quantify the importance of human capital, you need to estimate the “market value” of the client’s future earnings. It’s easy to do so:

1. Estimate the client’s future earnings.
2. Choose a discount rate that reflects the risk of the client’s earnings. For example, if you think the client’s earnings are risky like a stock, then choose a discount rate similar to the expected return on an equity portfolio.
3. Use present value math to determine the risk-adjusted value of the client’s future earnings.

The resulting calculation puts human capital on an apples-to-apples basis with the market values of investments, homes, and other assets.

An example

Imagine a couple in their early 30s who are planning to work for another 35 years. They earn $200,000 per year between the two of them, have a 20% tax rate, and their income grows by 1% per year above inflation.

If we apply a 5% discount rate, the present value of their human capital is approximately $3 million.

How human capital can impact client decisions

A broader understanding of lifetime wealth can significantly change the way people choose to plan and invest.

For example, let’s imagine that the same couple has $100,000 in the bank. How should they invest that money? Conventional wisdom would tell them to invest in equities, since they are “young and able to take risks.” However, it’s unlikely that doing so would have much of an impact on their long-term financial outcomes – a $100,000 portfolio is insignificant relative to their total lifetime wealth.

Here’s another idea: use that money to derisk their careers. Right now, career earnings are their main instrument for wealth creation, so positioning them for long-term career success should be a top priority.

To start, they could create a safe reserve fund to buy time to confidently search for the best possible job following a job loss. Being forced to compromise on a career path to pay short-term bills can have a major impact on long-term wealth creation, and a reserve fund directly addresses this risk.

Next, obtaining life, disability, and professional liability insurance could be worthwhile to derisk their financial picture. Doing so could help protect their dependents and mitigate the impact of unexpected events.

Beyond risk management, they could consider opportunities to invest in their careers. Maybe they decide to set aside burn-rate funding to support a career transition or entrepreneurial venture that could result in major payoffs down the line. Maybe they consider opportunities to invest in their skills and credentials through an advanced degree or professional certification. For a wealth-building family, these are the types of decisions that can have a major impact on long-term wealth.

The bigger picture

Once clients understand the lifetime value of their human capital, the question shifts from “how do I maximize investment returns?” to “how do I increase my potential for long-term wealth creation?”

For young, wealth-building individuals, the answer is likely to involve investing in their careers. For families approaching retirement, the investment portfolio is naturally going to play a more central role. For those in between, the goal is to integrate career decisions, the investment portfolio, and the broader wealth management strategy so that each supports the others.

In every case, advisors are in a unique position to connect the dots for their clients, going beyond the portfolio and delivering advice that addresses clients’ total wealth.

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