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Why clients are their own most valuable asset

Apr 23, 2014 @ 1:29 pm

By Darla Mercado

Earnings power, retirement, Morningstar, Barclays corporate indexes, human capital
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A new risk factor has been identified for financial advisers who are helping clients save for retirement: the person's earnings potential and career path.

On Monday, Morningstar Inc. unveiled a research paper entitled “No Portfolio is an Island,” authored by David Blanchett, head of retirement research at Morningstar Investment Management, and Philip Straehl, senior research consultant and portfolio manager at Morningstar Investment Management.

“Many [advisers'] perspectives of portfolios view them as islands and ignore other risk characteristics,” Mr. Blanchett said. Essentially, the investment portfolio is viewed in its own context and doesn't take into consideration other assets the client owns, particularly what is called “human capital” — an individual's potential growth in earning power as he or she progresses in his career. Generally, a younger person with a long career ahead has more human capital than an individual who is about to retire.

(See also: To Roth (IRA) or not to Roth, that is the question)

Advisers shouldn't give short shrift to a client's potential earnings. Mr. Blanchett notes that there are unique risk characteristics for each investor based on the industry that he or she works in. The investor's portfolio holdings ought to reflect those risks.

Perhaps the best example of how “outside” influences from a client's career path can influence their holdings is to consider the Enron Corp. scandal: Those employees held loads of company stock in their 401(k) accounts, which were decimated when the company's stock price tanked. There also was a ripple effect throughout the Houston community where Enron was based, as some 4,000 people were let go.

“When all of the risks happen at once, then it's a shock to your wealth,” Mr. Blanchett said.

What advisers need to bear in mind is that the value of the ability to build wealth changes over time. When the economy is faring poorly, an employee's earning power becomes stock-like, or more volatile, he said. Some industries have unique discount rates, or values of earning power based on the Barclays corporate bond indexes, which will also fluctuate.

In the study, Mr. Blanchett and Mr. Straehl selected 10 industries for their analysis: construction, finance, government, health care, lodging, manufacturing, mining, real estate, transportation and utilities. The researchers then used a combination of wage growth data and the yield from corresponding Barclays' corporate bond indexes as a proxy to determine the value of earning power for a given industry.

Finally, Mr. Blanchett and Mr. Straehl examined the correlations between the fluctuations of earning power for the 10 industries versus an array of asset classes.

The analysis led to some interesting conclusions: There were certain asset classes that had high correlations with certain industries. Most notably, for instance, the correlation between the earnings power of the real estate industry and the return on REITs is 0.602, which suggests that changes in REIT values are strongly tied to the wages in the real estate industry.

“The obvious implication is that individuals who work in the real estate industry should likely have a lower (or no) allocation to REITS in their financial assets than individuals who work in other industries,” Mr. Blanchett and Mr. Straehl observed in their report.

At the same time, the earning power of someone who works for the government has a 0.691 correlation to intermediate bonds and a 0.696 correlation to long-term bonds. But a -0.048 correlation to large-cap growth stocks and a 0.078 correlation to large-cap value.

Assuming that earning power is assumed to be 80% of a person's total wealth, with the remaining 20% being financial wealth, advisers will need to tweak clients' holdings accordingly.

For instance, the individual who works for the government and whose earnings power is highly correlated to intermediate and long-term bonds may want to eschew those long-duration bonds and instead allocate 16.4% of his or her wealth to large-cap growth, 16.1% to small-cap growth, 20% to small-cap value, 20% in Treasury inflation-protected securities, 4.2% in intermediate bonds and 14.9% in cash, per Morningstar's research.

As far as integrating the question of future earning power, pensions, real estate and other sources of “hidden” wealth, financial advisers ought to address the full array of clients' risk factors. “Tell me about your pension, your home, the amount of savings you have, how leveraged your home is,” Mr. Blanchett said. “What are the risks of everything you own?”

“Total wealth should affect every investor,” he added.

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