Journal of Financial Planning: February 2021
Inga Timmerman, Ph.D., CFP®, joined the faculty at California State University, Northridge in 2015 and is the Dr. Mary Jean Scheuer Professor of Finance. Her research is mostly concentrated around corporate finance and financial planning. Timmerman’s current projects explore the use and perceptions individuals have about the financial planning profession and the drivers that motivate people to save.
Nikanor Volkov, Ph.D., CVA, MAFF, is an assistant professor of finance and director of the master’s in business analytics program at Mercer University, where he teaches various finance classes at the undergraduate and graduate levels. His research interests are in the areas of information disclosure, investments, investor behavior, financial planning, and forensic economics and finance.
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Editor’s note: This article is a shortened version of the authors’ research, originally published in Financial Services Review, issue 28, No. 3. The Journal of Financial Planning republishes, with permission, shortened versions of research originally published in Financial Services Review as part of a partnership between FPA and the Academy of Financial Services to bring relevant research from Financial Services Review to Journal readers. Financial Services Review retains all copyrights to this published research.
While the conventional approach to measuring individual wealth is through an estimation of the dollar value of financial assets (cash, stocks, bonds, etc.) and real assets (real estate, private business, etc.), such a view deemphasizes human capital. Yet, human capital, rather than financial capital, is responsible for the bulk of the wealth for most individuals during most stages of their lives, especially during their younger years. Furthermore, the value of an individual’s financial and real asset portfolio often reflects the human capital1 value possessed by the individual in the past because a relationship exists between the value of human capital and an individual’s long-term financial wealth.
Despite the financial importance of the topic for an average individual, there is not much research in financial planning that focuses on the optimization of lifetime earnings. This is understandable given that financial planners do not have much input into the career paths or education levels of their clients. Traditionally, by the time one becomes a financial planner’s client, he or she is already in the asset (financial and real) accumulation or decumulation phase. At that point, the goal of a financial planner is to maximize the value of the existing assets and/or cash flows. Nevertheless, given the apparent shift in the financial planning profession,2 such as the attempt to work with younger and less affluent clients and the emergence of a new type of planner (one who seeks to work with the younger population), planners who compete for the business of younger clients and who strive to help clients through the entire lifespan should prioritize development of their clients’ human capital, along with value-maximization of clients’ financial capital.
The Value of Human Capital
The value of human capital is primarily driven by an individual’s skills, which, in turn, results from: (1) education level, (2) career choice, and (3) experience. Financial planners can help their clients decide what to study and where to study.3 By developing a framework that will incorporate human capital (the biggest asset an average younger client can bring to a planner’s attention) into the conversation of overall wealth maximization, advisers can help their clients achieve financial goals more effectively and efficiently. The objective of long-term financial planning is to ensure that, at some point in time, the return from the financial and real asset portfolio fully substitutes for the need to produce financial return on the possessed human capital (retirement). There exists a clear and, arguably, non-linear relationship between the value of human capital and the long-term value of one’s financial and real asset portfolio.
In our study published in Financial Services Review,4 we developed a model that incorporates the value of human capital into the framework of overall financial wealth for an average individual. We showed that, despite one’s preferences for academic majors and career paths, one can still make optimal financial decisions within the chosen career path by examining the lifetime earnings across several sub-dimensions within the career of interest. Our contribution to the current literature is in presenting a model that can be used to maximize the individual’s wealth portfolio through an emphasis on the financial implications of a given education level and career path. The model also demonstrates that inclusion of human capital in the individual’s portfolio choice problem maximizes the value of the Sharpe ratio, thereby optimizing the relationship between the expected return and the risk of the wealth portfolio.
Additionally, we provided several useful examples of the computation of the present value of the lifelong earnings for different education-occupation combinations. These calculations serve as a guide in making education and career choice decisions. Finally, we calculated the net present value of the difference between the average age-earnings profiles in given education with various education levels beyond high school and with high school education. The net present value represents a maximum expenditure one should be willing to incur for education beyond high school if his or her goal is to increase their overall wealth as the result of achieving the given level of education. In other words, the net present value represents the maximum tuition one should pay for the given education level beyond high school. The sample calculations are performed by occupation and are meant to aid in establishing an optimal education level for a given occupation. We are not suggesting that everyone should become a lawyer, doctor, or any other highly paid profession; our examples serve to demonstrate how an individual’s career and education level choice, even within a specific area of interest, can have a significant impact on their overall wealth maximization.
In order to provide meaningful results, we used the Bureau of Labor Statistics American Community Survey (ACS) for the recent period of 2012–2016. We identified individuals who are working full-time by including only the observations for individuals who indicated they were employed at least 50 weeks in the last 12 months and who worked at least 35 hours per week.
For illustrative purposes, one can make the following conclusions by looking at the Sales and Related Occupations SOC category at different levels of education.
Education levels of one or fewer years of college, one or more years of college experience, and an associate’s degree resulted in almost identical earnings for most occupations within this category. Bachelor’s degrees resulted in a very significant increase in the present value of earnings for all occupations in this subfield. Attainment of a bachelor’s degree or higher degree resulted in more income over the working lifetime of an individual in most of the subcategories of the sales profession. An individual who wants to pursue a career as a cashier has up to $35,435 dollars (in present value terms at age 18) to complete their bachelor’s degree to end up as well or better off than if they would have earned only a high school education. At the same time, he or she has only $8,668 to complete both bachelor’s and master’s degrees if they want to remain indifferent to just a high school diploma. Thus, an individual who wants to become a cashier should only earn a bachelor’s degree at a program that costs less than $35,435 over the entire course of study; furthermore, this individual should not consider a master’s degree, regardless of its cost, as the bachelor’s degree results in higher present value of future earnings than does the master’s degree for this occupation. These results are not surprising as cashier and parts salesperson positions do not typically require specialized skills beyond a basic level. As a result, they should not be rewarded for the extra level of education pursued and the cost incurred for obtaining such education.
By comparison, insurance agents can spend up to $286,964 on bachelor’s degrees and nearly an additional $57,000 on their master’s degrees to be better off than insurance agents with only a high school diploma. Securities, commodities, and financial services sales agents can spend up to $1,124,398 on their bachelor’s and master’s degrees and still be financially better off than someone who decided not to go to college. The master’s degree appears very beneficial in this position as it adds over $450,000 in value. A professional degree adds almost another $200,000 in value to an individual involved in this occupation, while a Ph.D. (doctor of philosophy) degree appears to be less valuable than a master’s degree in present value terms. As expected, the more specialized the skills required, the more the pursuit of additional education pays off. The appeal of presenting the information this way is that it gives consumers a way to evaluate whether pursuing a specific level of education or major is worth the overall investment. A very noticeable and important observation is that dropping out of college at any time or getting an associate’s degree is not a value-adding proposition for any of the occupations examined.
In our Financial Services Review paper, we combined the benefits of additional schooling and specific career paths available. This is a valuable tool for financial planners who aim to work with younger, career-changing, or education-pursuing clients. They can now frame the decision of obtaining more education in a more specific career path by analyzing the benefits of any additional degree or career option. By applying the theoretical model to specific occupations and levels of education, financial planners can speak with their clients about the lifetime benefit of obtaining such education and the maximum costs to obtain a degree.
We understand the limitations of applying a theoretical model for a practitioner and, as such, our next step is to develop a practical tool that financial planners can use in their work with clients. In the interim, the results from our study can be used to help frame the education planning conversations that financial planners have with their clients. Specifically, the results can be used to enhance financial planner and client dialogue around the value of higher education and the financial outcomes associated with investing in a particular degree program.
- In Joseph Stiglitz’s 2015 book Inequality, Wealth, and Capital, he provides the following definitions of wealth and capital: “wealth and capital are two distinct concepts; the former reﬂects control over resources, the latter is a key input into production processes.” While we acknowledge the subtle differences in the definitions, we often use the words interchangeably as the human capital element of overall individual’s wealth represents both control over resources and an input into the production process.
- See www.financial-planning.com/opinion/the-richest-advisors-are-targeting-millennials-now or www.thinkadvisor.com/2017/07/18/these-millennial-advisors-are-killing-it-with-youn/?slreturn=20181013183259.
- The Center on Education and the Workforce at Georgetown University has recently developed a ranking system of colleges in the United States by the return on investment in education (cew.georgetown.edu/cew-reports/CollegeROI/). While such a tool can certainly help in selecting a college to attend, it does not provide insight into the career and appropriate (from a financial standpoint) education level selection.
- See the original article, “Career and Education Choice as Central Elements of Long-Term Financial Planning,” in Financial Services Review, issue 28, No. 3.