Financial advisors can add value to their business by considering clients’ human capital — their career potential and ability to earn income — as part of the wealth management process, according to Stephen Horan, head of professional education content and private wealth at the CFA Institute.

Horan spoke about human capital at the Toronto CFA Society’s Wealth Management Conference this week. In an interview on Wednesday, he explained that investors’ human capital is often ignored in the financial planning process, since many advisors focus on the assets that clients have already accumulated.

“Before you can advise any client with regard to asset allocation or anything else, you need to take an inventory both of what their investment goals are,” Horan explained, “as well as an inventory of what their available resources are to meet those goals.

“What’s sometimes not fully considered is the fact that probably the largest resource available to us to meet those goals is not the money we have in the bank or in our brokerage account, but it’s the value we derive from our employment, or our career,” he added.

In other words, an effective financial plan should be designed around not only the assets that a client already has, but the potential they have to continue accumulating assets in the future.

This is important because for most clients, their “economic value” is largely based on their ability to earn income, according to Horan. For young clients who haven’t accumulated many assets yet, he estimates that human capital comprises up to 90% of their economic value; and for clients over the age of 50, it still represents half of this value, on average.

“I think it’s important, because it represents 50% or 70% of your economic value — and everyone else is ignoring that chunk,” Horan said.

How to assess a client’s human capital

A growing number of advisors are beginning to recognize the importance of human capital and are incorporating it into the wealth management process, according to Horan. The first step is to determine the size of a client’s human capital: how much they are currently earning, and how much potential they have to increase this amount over time.

Second, he said it’s critical to define the nature of their human capital, including how volatile or steady their income is, and how transferable their skills are. These factors will have key implications for the client’s risk tolerance.

For example, a client who works as an investment banker would have a salary that can fluctuate dramatically depending on the state of the markets.

“Their living is actually subject to a fair amount of volatility,” Horan said, explaining that as a result, that client would be advised to take less risk in their investment portfolio under the human capital approach.

As another example, a client with a wide range of skills that are transferable between firms and between industries would have a small chance of ending up unemployed for an extended period of time. Since that client’s employment income would be considered reliable, they could theoretically take on more risk in their investments.

Someone with a more specific skill set may face greater risks in their employment income, and would therefore be advised to take on fewer investment risks.

“The more narrowly specific your human capital is, all else equal, the less risk-tolerant you’re going to be in your investment portfolio,” Horan said.

Benefits of considering human capital

Incorporating these considerations into your practice could help you differentiate your practice in the marketplace, according to Horan.

“You can add value to the advisory relationship by taking a comprehensive view of who your client is, and a broad view of where their economic value comes from, and what it’s going to be used for,” he said.

In addition, he said the approach provides an effective opportunity to get to know your client. He urges advisors to preface the conversation by explaining to the client that it’s important for you to understand their career and their ambitions in order to provide them with advice that is specifically catered to their circumstances.

IE