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Accounting for Illiquid/Intangible Assets on Your Household Balance Sheet

A reader writes in, asking:

“What do you think about including the present value of human capital, social security, pensions, etc when calculating your asset allocation? I have read about doing so in various sources over the years, but it strikes me as the sort of thing that makes sense in an academic world but causes problems if actually attempted in real life.”

I’ve written about this before with regard to Social Security, but my thoughts are similar regarding other such assets (and liabilities).

Human capital: it’s not a stock. It’s not a bond. But it is a very real asset (unless of course you’re permanently retired/disabled).

Social Security: it’s not a stock. It’s not a bond. But it is a very real asset.

Your home, if you own one: it’s not a stock. It’s not a bond. But it is a very real asset.

Future consumption: it’s not a stock (or a negative stock). It’s not bond (or a negative bond). But it is a very real liability.

Point being, yes, you should be thinking about all of those things when you make financial planning decisions. But I don’t think it makes a lot of sense to try to lump them into categories in which they don’t really belong.

But what does it mean to be thinking about these things when making financial planning decisions?

Let’s go through some examples.

An asset allocation that’s appropriate for somebody with a safe job in a safe field (e.g., a tenured professor) may not appropriate for somebody with a very risky job in a very risky field (e.g., a sales position for a start-up), even if everything else about the two people is exactly identical.

That doesn’t mean that we should calculate the present value of each person’s human capital, assign that human capital a stock/bond rating (e.g., “Sarah’s human capital is 30% stock, 70% bond”), and then rebalance accordingly every year. Because doing that can lead to all sorts of wacky decisions. For example, such an approach could require a 25-year old to shift her 401(k) allocation wildly back and forth from one year to the next, because her financial assets are a very small figure relative to her human capital, so any changes in the human capital could require massive changes to the allocation of the financial assets.

But yes, if you have a riskier job, you should probably have a safer portfolio. And it’s really not a good idea to fill your financial portfolio with assets that would be highly correlated to your human capital. For example, if you work in the tech sector, you probably don’t want to have tech stocks dramatically overweighted in your portfolio. And it’s really, really not a good idea to have a big part of your portfolio invested in your employer’s stock.

As far as Social Security and pension income, if your spending needs are completely (or mostly) met by such safe sources of income, then you can afford to take on more risk in your portfolio than if your guaranteed income sources were very small relative to your spending needs. But that doesn’t mean that you need to be regularly recalculating the expected present value of your pension assets and including that figure in the math every time you rebalance your portfolio.

Or, consider two retirees whose circumstances are exactly identical, except that one owns her home and the other rents. The homeowner is meaningfully less exposed to inflation risk, and that could inform the asset allocation decision. In addition, that home is a chunk of wealth that could be turned into spending if necessary (e.g., via a reverse mortgage). And that likely means that the homeowner can safely spend a greater dollar amount per year than the renter. But again, that doesn’t mean that we should pretend the home is some sort of stock/bond hybrid and include that in the portfolio rebalancing math.

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