One of the financial goals we hear plenty about is the need to save and invest for our retirement.
We’d all like to retire with enough financial resources to at least maintain our living standards after we’re done with work.
Unfortunately, most of us start planning for retirement five to 10 years to the end of our work life.
Two main ideas matter getting retirement planning right. First is human capital, which is the present value of your total expected future wages – or simply put, it’s the return you earn for investing your time and skills in your job.
Human capital is one of the most valuable assets we own, especially when we’re young, but it tends to be the most ignored in planning for retirement.
Second is financial capital, which is the combined tangible and intangible assets you own that are not human capital, for instance your home, stocks and fixed deposits.
When planning for retirement, these are the points to consider.
1. The younger you are, the higher your human capital
This is because you have more years to receive labour income. Take the example of Mary, who’s 25, and John, who’s 40. Both intend to retire at 60.
Mary has 35 years of labour income she can continue to earn, while John has only 20 years of labour income. So as you age, your human capital reduces, and your reliance on financial capital increases. You now need to earn more from your financial capital to replace the human capital that declines to zero on retirement.
At retirement, you only have financial capital, no human capital. Therefore, your goal is to build up financial capital over the years to an amount that matches or exceeds your needs,
2. The type of job you do determines your human capital
Factors that affect human capital include job stability, earnings volatility and industry.
When your earnings are volatile – say, you’re a real estate agent earning commissions, it’s difficult to predict your earnings, and hence they are ‘stock-like’. If you have a fixed income from your job, then your earnings are ‘bond-like’.
It is advisable for those with ‘stock-like’ earnings to concentrate their investments in less volatile investments, such as fixed-income securities, while those with ‘bond-like’ earnings can invest in stocks.
3. Individuals go through different stages of life
These stages lead to variations on the ratio of human capital to financial capital, and different ideas on optimal investments:
a. Training stage: Most investors start out in this stage where they are learning the ropes of their profession, have low financial capital due to low wages, and expenses like education. At this stage, their human capital is very high. Investments should focus on stocks or similar investments. Risk tolerance is high as there is room to recoup any losses, should they occur.
b. Accumulation stage: This stage largely comprises those aged 30 to 50, whose human capital is declining but they have, or should ideally have, steadily increasing financial capital. They’re preparing for retirement, where their needs will be met from financial capital earnings like a pension, rental income or interest from fixed-income securities.
The proportion of real estate and bonds should increase gradually as stocks decline. Risk tolerance is still high but diminishing.
c. Retirement stage: At this point, human capital is zero and financial capital should be sufficient to the earnings from human capital or even higher.
Investments should largely be in bonds and other fixed-income investments. Risk tolerance is low as there is no scope for earning human capital or recovering from losses in financial capital
4. Given its importance, protect against losses in human capital
You lose human capital through things like disability or a reduction in professional competency. The higher the human capital, the more the need for protection from its loss. Those in the training and early accumulation stages have a higher need for life and disability insurance, as this could drastically cut down their human capital, and since they may not have sufficient financial capital, they may be left without enough to survive on.
5. Build up your human capital
You can increase your human capital by actively seeking to boost your professional and social skills, and getting certifications.
6. Don’t take financial capital for granted
Financial capital must be built up, it doesn’t just fall on your laps. Take advantage of opportunities to convert human capital into financial capital, especially by investing and while at the training stage. The longer you have to retirement, the higher your potential human capital. Sacrifice a little time to by taking courses, learning new skills and so on.
7. Spend less and invest more
As cliché as this may sound, it is the optimal plan. The earlier you invest in financial capital, the more time it has to grow. The cardinal rule in planning for retirement is start early. Start early to grow your human capital and also to convert your human capital into financial capital.
The writer is Cytonn Investment’s diaspora co-ordinator.