At a conference hosted by Boston University in 2006, Nobel Prize-winning economist Paul A. Samuelson asked the audience whether personal finance was an exact science. He answered his own question with remarkable wit and wisdom: “Of course, the answer to that is a flat no. If this disappoints anyone in the audience, now is a good moment to rectify your miscalculation by leaving.”
Yet one of Mr. Samuelson's many contributions to the field of economics has been to build mathematical (dare we say, “scientific”) models to better understand how to optimize personal finance decisions, such as: How much should individuals save for retirement? How should they allocate their investment portfolio throughout their lifetime?
Mr. Samuelson's models have evolved over time. Expanding on them, Bob Merton, Zvi Bodie and others have argued that human capital — the present value of an individual's future salary income — is an “asset” just like stocks and bonds, and should be considered as part of the life-cycle asset allocation decision.
Human capital also drives the retirement liability. When they reach retirement, individuals need an income stream to meet their spending goals, usually some portion of their salary just before retirement. With defined benefit plans, this liability is explicitly defined; accordingly, a majority of DB plans employ liability-driven investment strategies. This approach has also been making its way into portfolio construction models for target-date funds, which are used in defined contribution plans.
Overall, the concept of human capital makes a lot sense. However, we believe the conclusion reached by most industry participants regarding its impact on the asset-allocation decision is wrong.
Because salary payments are relatively steady month-to-month, conventional wisdom is that human capital is bond-like, and therefore, it should be hedged with bonds. In recent years, Mr. Bodie has even gone so far as to suggest that most individuals should invest 100% of their retirement savings in a TIPS portfolio, to safely match their retirement spending goal.
Is that sound advice? Echoing Mr. Samuelson: The answer is a flat no. While bonds will always have their place in balanced portfolios, ultimately we believe that individuals are more likely to reach their retirement goals with stocks.
The asset-side case for stocks is unambiguous. Estimates from our record-keeping data suggest that individuals save about 30% less than they should to reach their retirement goals and are severely underfunded.
With 30-year nominal bonds currently yielding 2.3% (and 30-year TIPS currently yielding 0.6%), bonds will not bridge the underfunding gap for individuals. Suppose TIPS generate 0% real return (not a far-fetched assumption), and an individual saves 10% of their consumption per year to buy TIPS. In this zero-return environment, it will take the bond investor roughly nine years to save enough to replace one year of consumption in retirement, assuming salary remains constant.
On the liability side, most people think that bonds hedge human capital better than stocks. However, when stocks do well, salaries tend to increase due to earnings growth (and vice-versa when stocks do badly). From that perspective, human capital has a “positive equity beta.”
Looking beyond month-to-month correlations and focusing on rolling three-year return correlations, we find that net of inflation, the average-wage index is more correlated to stocks (+53%) than to bonds (+30%), based on data from 1952 to 2014.
Of course, stocks have greater exposure to loss than bonds. As individuals approach retirement, they can mitigate this downside risk with an increasing allocation to bonds. But in the final analysis, which is the best long-term retirement portfolio — bonds, or a balanced portfolio with a healthy allocation to stocks? We believe it's the latter. (And if this answer disappoints any of our readers, now is a good time to rectify your miscalculation by moving on to another
InvestmentNews article.)
Sebastien Page is co-head of the Asset Allocation Group at T. Rowe Price. James A. Tzitzouris is director of research of the Asset Allocation Group at T. Rowe Price.
