Understanding Your Capital
By Doug Short
July 27, 2011
Note from dshort: Here is an update on a topic I posted following my speaking engagement at the Retirement Industry Income Association (RIIA) spring conference. I will speak again at the RIIA Fall Conference in October. I hope to meet some of you there.
For many years financial planners embraced the image of a three-legged stool to illustrate sources of retirement income:
● Social Security
● Personal Savings
Of course, as we all know, for most people the stool now has only two legs, making it a rather wobbly support. Over the past few decades, private pensions have essentially disappeared. They may still be available for government and some union employees, but pensions in the world of private business are generally available only to a shrinking number of older workers who were grandfathered into a now closed system.
There is, however, a better model for explaining sources of retirement income, and it too fits the three-legged stool analogy. The Retirement Income Industry Association (RIIA) uses the concept of Capital to identify the three sources of retirement income:
● Human Capital
● Social Capital
● Financial Capital
Human Capital is your earning power — cash received for goods produced or services rendered. For most households, Human Capital in the form of wages or small business revenue is the main source of income during their pre-retirement years.
Social Capital, as RIIA defines it, is your claim on the Human Capital of others. Social Security is the largest source of Social Capital. But this category would also include pensions, other government entitlements (Medicare, Medicaid, the Supplemental Nutrition Assistance Program, etc.), financial assistance from relatives and friends, and support from religious or civic organizations.
Financial Capital is the sum of your savings and investments. These would include tax-advantaged savings plans, such as 401(k)s, 403(b)s, traditional IRAs, Roth IRAs, etc., and taxable accounts. This is the category that has been the focus of traditional financial planning. Unless you win the lottery or inherit a fortune, Financial Capital is the result of a long-term process of converting a portion of our Human Capital. Households consume most of their Human Capital in the cash outflows of daily living. In contrast, Financial Capital is essentially a mechanism for deferred consumption — saving some of your disposable income today for future spending. The goal may be near-term, such as a down-payment on a home or college tuition for a child. But the major goal is to save for retirement expenses that won't be covered by Social and Human Capital.
Human Capital: The Key Difference between the Old and New Stools
When we compare the old and new stools, we see that two of the old legs, Social Security and pensions, have been combined into the single leg of Social Capital in the RIIA paradigm. In addition, RIIA adds the new third leg, Human Capital, formerly the mainstay of our pre-retirement years. Why? The reasons are simple enough. Many households nearing retirement during the Lost Decade had their Financial Capital dramatically reduced by the Tech Crash and the Financial Crisis. They must either delay retirement or include some Human Capital activity (work) to keep their Capital flowing. Then too, there is the discovery by many retirees that part-time work or income-producing hobbies offer as much (and for some of us more) fulfillment than a life of leisure.
The Retirement Income Industry Association has created a new professional designation, the Retirement Management Analyst℠ (RMA), for financial planners who want to focus on retirement preparation and strategies for ensuring that our income needs are met during our golden years.
The concept of three types of capital for retirement income is but one of many core concepts in the RMA body of knowledge for this designation. In future posts I'll examine some additional concepts that set RMA designees apart from traditional financial planners, who generally have more expertise on asset accumulation strategies than on managing the ongoing task of generating retirement income.