Dario Castagna, Hal Ratner, - Morningstar, Inc.media.morningstar.com/.../4_Hal_Ratner_final_.pdf · Portfolio LT Bonds Large Cap Stocks International Stocks Emerging Market Stocks

Prof. Giorgio Di Giorgio, Dean, Economics and Finance, LUISS University, Rome

Consigliere indipendente di Eurizon Capital SGR

For Financial Professional Use Only. Not For Public Distribution.

©2012 Morningstar, Inc. All Rights Reserved. These materials are for informational and/or illustrative purposes only. Morningstar Investment Management is a division of Morningstar, Inc., which includes Morningstar Associates, LLC, Morningstar Investment Services, Inc., and Ibbotson Associates, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited.

Prof. Giorgio Di Giorgio, Dean, Economics and Finance, LUISS University, Rome

Consigliere indipendente di Eurizon Capital SGR

Paul Kaplan, Ph. D., CFA, Quantitative Research Director,

Morningstar Europe, Ltd.

Dario Castagna, CFA, Investment Consultant,

Morningstar Investment Management, LLC.

Hal Ratner, Chief Investment Officer Europe,

Morningstar Investment Management, LLC.

Hal Ratner

CIO, Europe

Human Capital & Asset Allocation: Beyond the Traditional Concept of Wealth

For Financial Professional Use Only. Not For Public Distribution.

©2012 Morningstar, Inc. All Rights Reserved. These materials are for informational and/or illustrative purposes only. Morningstar Investment Management is a division of Morningstar, Inc., which includes Morningstar Associates, LLC, Morningstar Investment Services, Inc., and Ibbotson Associates, Inc., all registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited.

Hal Ratner

CIO, Europe

Morningstar Investment Management, LLC

March 20, 2012

× Defining Human Capital

× Modeling Human Capital

× Integrating Human Capital and Asset Allocation

Examples

Agenda

Morningstar Investment Management

For Financial Professional Use Only. Not For Public Distribution.3

× Examples

Human Capital



Human Capital—Why it Matters

× People invest to consume

× People derive utility from planned consumption not wealth.

× Strategic asset allocation must be based on these



× Strategic asset allocation must be based on these concepts.

Human Capital—Not a New Idea

Not A New Idea

× Adam Smith

× Karl Marx (weak form—labor power)

× Arthur Pigou

Jacob Mincer (i.e. “Investment in Human Capital and



× Jacob Mincer (i.e. “Investment in Human Capital and Personal Income Distribution” Journal of Political Economy 1958).

× Gary Becker (i.e. “Human Capital” 1964).

× Robert Merton (1969)

× Paul Samuelson (1969)

Theory into Practice

Morningstar/Ibbotson



Human Capital

× Human Capital is market value of the skills, education, intelligence, charisma, creativity, experience, and specialized skills one brings to the labor market.

× From an economic perspective, human capital is the present



× From an economic perspective, human capital is the presentvalue of future labor income

× Human Capital has no intrinsic value. It is continually re-priced by

the labor market.

Human Capital

Characteristics of Human Capital

× Often investor’s largest asset

× Consumed through time (e.g. younger investors have more than older investors).

× Cannot be traded



× Cannot be traded

× Value and risk characteristics depend on age, income, gender, education, health, etc.

× Value will change as pricing variables change (e.g. more education, change in job market).

×Human Capital has no “intrinsic value” it is continually priced by the labor market.

Everyone is Different

Many people at the same age have different HC endowments



EntertainerUniversity Professor Artist

How Stage of One’s Career Impacts Human Capital



How Volatility of Earnings Impacts Human Capital

/Artist



Total Economic Wealth

Financial Capital

+

Human Capital



× Tradable assets such as stocks and bonds have traditionally been used when constructing an asset allocation

× Incomplete without considering Human Capital

× An individuals ability to earn and save

× Present value of all your expected future wages including pension and social security

Lifetime Risks: Accumulation Phase

Expense Risk Market Risk

Savings Risk

Asset Allocation Decision



Mortality Risk

Lifetime Risks: Disbursement Phase

Expense Risk Market Risk

Bequest Risk

Asset Allocation Decision



Longevity Risk

Typical Life Cycle of Human Capital and Financial Capital



Risks in Accumulation

�Expense Risk

�Savings Risk

�Mortality Risk

�Market Risk

Risks in Retirement

�Expense Risk

�Bequest Risk

�Longevity Risk

�Market Risk

Human Capital & Asset Allocation



Individual Balance Sheet

Assets Liabilities

Financial Capital

Human Capital

PV of Earnings used for Pre-Retirement Expenses

PV of Earnings directed toward Savings

PV of future Social Security and Pensions

Future ExpensesPV of Pre-Retirement Expenses

PV of Post-Retirement Expenses

PV of Bequest



PV of future Social Security and Pensions

Surplus (Deficit)

What is the true risk of any portfolio that exists to pay for a liability?

× It is NOT the standard deviation of the asset portfolio

× It is NOT the performance of your asset portfolio relative to the asset portfolios of your peers

× The TRUE risk is that it won’t be able to pay for the liability!

Liability-Relative Optimization

× Liability-relative optimization is a special case (or extension) of traditional mean-variance optimization in which the optimizer is constrained to hold a combination of assets representing the liability short

× Assets exist to fund liabilities; therefore, liabilities and the risks associated with liabilities should be incorporated into the decision framework.

× Liability-relative optimization focuses on the entire portfolio – assets and liabilities



Ex

pecte

d R

etu

rn

Standard Deviation

Traditional

Frontier

Liability-Relative

Frontier

× Resulting in a portfolio that better manages inflation and market risk

Typical Glide Path

60

80

100

Equit

y E

xposu

re (

%)

BondsWithin Bonds

• Long Duration Bonds• More Nominal Bonds

Within Stocks

•Higher International•Higher Emerging•Higher Small Cap Within Bonds

• Begin Shift toInflation-Protection Bonds

Within Stocks

• Average International• Average Emerging• Average Small Cap

Within Bonds

• Shorter Duration Bonds• Higher Inflation-

Protection Bonds



0

20

40

20 30 40 50 60 70 80 90Age

100

Equit

y E

xposu

re (

%)

Stocks

20 25 35 45 55 65 75 85

Age

• Average Small CapWithin Stocks

• Lower International• Lower Emerging• Lower Small Cap• Higher REITs

Modern Portfolio Theory: Markowitz’s MVO and Sharpe’s CAPME

xpecte

d R

etu

rn

Max Sharpe Ratio

Portfolio

LT Bonds

Large Cap Stocks

International Stocks

Emerging Market Stocks

Stocks: 46%

Market PortfolioHuman Capital

(Bond-like Characteristics)



Ex

pecte

d R

etu

rn

Retirement Income Liability

(Short TIPS-like characteristics)

Cash

Inflation-Linked

LT BondsStocks: 46%

Bonds: 54%

0

Targeting the Market Portfolio

54+

Human Capital Market Portfolio

Ú

Financial Capital

?30 46



54+ Ú


?70

46

Stocks (%)

Bonds (%)

Other Considerations

× Risk capacity

× Risk preference

× Taxation

× Liquidity



Risk Preference

Market Portfolio Definition

Conservative

+

Human Capital

Ú

Financial Capital

30

70

? ?

Moderate

Stocks (%)

Bonds (%)64

36



+ Ú? ?

Aggressive

+ Ú? ?

4654

56 44

30

70

30

70

Risk Preference With Average Human Capital

Risky Market Portfolio60

80

100

Equit

y E

xposu

re (

%)



Average Market Portfolio

Conservative Market Portfolio

0

20

40

20 28 36 44

Age

60

Equit

y E

xposu

re (

%)

52 68 76 84

Hedging Mortality Risk



Life Cycle of Human Capital – Hedging Mortality Risk

$800,000

$1,000,000

$1,200,000

Insu

rance N

eed



$0

25 30 35 40 45 50 55 60 65

$200,000

$400,000

$600,000Insurance Need

Insu

rance N

eed

Age

Life Insurance

Questionnaire

used to assess:

Life Insurance Questionnaire – Hedging Mortality Risk

Financial Situation

×Financial Wealth

×Current income level



Subjective Factors

×Human Capital

×Consumption vs. Bequest

Hedging Mortality Risk

Human Capital

Asset AllocationDecide if need Mutual Funds, ETFs, Separate Accounts

Inputs Outputs

Financial Capitaland Current Savings



Questionnaire Collect info such as: age,income, bequest preference, dependents, life expectancy, risk tolerance

Ins Life Insurance Face Value CMA

Capital Market Assumptions

and Current Savings




Case Study



Case Study

Joseph Horton Account Manager Advertising firm

Children 2

Profession

Wife, School Teacher

Teenagers



Case Study – Joseph Horton

Your Human Capital is estimated at $1,900,000. This is an assessment of the present value of your expected future labor income including applicable Old Age Security and pension benefits.



pension benefits.

Case Study – Joseph Horton



$600,000 Face Value

Target Maturity Glide Path Style Box



Conclusion

× Human capital is the sum total of one’s skills and is represented as the present value of future labor income

× Human capital is often an individuals largest asset

× A better understanding of human capital allows us to make better financial decisions and apply our skill sets more appropriately



financial decisions and apply our skill sets more appropriately

× Consider the current value of your clients human capital when constructing their financial portfolios.



Documents

Dario Castagna, Hal Ratner, - Morningstar, Inc.media.morningstar.com/.../4_Hal_Ratner_final_.pdf · Portfolio LT Bonds Large Cap Stocks International Stocks Emerging Market Stocks