TARGET DATE FUNDS

Human capital and target
date funds

Jan 18, 2017
By BlackRock

Why understanding income data should drive the glidepath

Every target date fund makes explicit or implicit assumptions about human capital, which is the estimated value of an individual’s future wages. This estimated value, the rate at which human capital is converted into financial capital through labor income, and the degree to which human capital offsets portfolio risk, are the foundation of a target date fund’s glidepath.

BlackRock’s Multi-Asset Strategy team systematically evaluates the LifePath® glidepath using a robust set of human capital assumptions. The assumptions are based on real-world income data, combined with longevity data and participants’ lifetime consumption preferences.

Our view

How target date fund providers quantify the present value of future wages, including accounting for the rise and fall of wages over time, the effects of education and longevity, and the potential for income disruptions, is the key — and perhaps least understood — differentiator among the glidepaths. The human capital model for LifePath target date funds considers the following.

Labor income risk


Labor income risk

The model seeks to capture the variation in the wages individuals earn during their careers, or labor income risk. This risk comes in two forms: permanent and temporary variability. Permanent variations are changes that have some amount of income persistence year to year, such as a raise in salary. Temporary variations refer to ups and downs such as a job loss or a one-time bonus that will not permanently change your income projection in subsequent years.

An accurate labor profile, complete with temporary and permanent variability, should ultimately consider an individual’s education, location, gender, and type of activity, all of which can have a significant impact on appropriate asset allocation. For example, agricultural workers have high year-over-year income variability and therefore may not want to be invested entirely in stocks.

Impact on asset allocations


Impact on asset allocations

For the purposes of asset allocation, human capital is considered non-tradable wealth. An individual can consider it as part of their personal balance sheet as an asset but cannot immediately or fully convert it into financial capital. That’s why with this large amount of non-tradable wealth as the cornerstone of their asset allocation early in life, individuals can afford to take additional risk exposure with their financial wealth. Assuming human capital decreases over time and financial capital increases, we believe the amount of risk an individual should take with their financial assets should be reduced, leading to a larger allocation to more conservative investments.

Correlations with retirement outcomes


Correlations with retirement outcomes

The importance of accurately modelling human capital can be clearly understood when we consider variations in human capital. Numerous factors, such as the income replacement a high school-educated worker may expect from Social Security, can have an effect on the risk level of an individualized glidepath. While this disaggregation demonstrates our deeper understanding of this data, it is important to note that the participant population of most large DC plans often closely resembles the aggregate data.1

U.S. income profiles by education level

U.S. income profiles by education level

Source: The Review of Financial Studies Vol. 18, No.2: Consumption and Portfollio Choice over the Lifecycle. Feb. 10, 2005. Labour income processes estimated from the PSID for the three different education groups: households with high school education but without college degree, and college graduates. Starting salary point($32,000)is assumed to be consistent across education levels for illustration purposes only.

Bottom line

Capturing the robust characteristics of how human capital is created, evolves and is consumed over a lifetime is crucial to the creation of an asset allocation and the overall effectiveness of a workplace savings plan for participants. Due to the robustness of the human capital model, the LifePath Research team has the statistical dexterity to customize for an individual or a specific group of individuals’ education, experience and industry in modeling human capital. When aggregated, this broad universe of data leads to the construction of the specific glidepath for the LifePath series of funds.

LEARN MORE