Why human capital and liabilities have implications for how we build financial plans.

On this episode of The Long View, Tom Idzorek, chief investment officer of retirement for Morningstar Investment Management, and Paul Kaplan, who before retiring in 2023 was the director of research for Morningstar Canada and a senior member of Morningstar's Global Research Team, discuss human capital, asset allocation, and key takeaways from their new book, Lifetime Financial Advice: A Personalized Optimal Multilevel Approach.

Here are a few highlights from Idzorek and Kaplan's conversation with Morningstar's Christine Benz and Jeffrey Ptak.

Jeff Ptak: I wanted to talk about human capital and liabilities, a concept that's very much central to the overall framework that you present in the book. Paul, for this one, I'll turn to you. How does the inclusion of human capital and liabilities into what you might call an economic balance sheet? How does that enhance traditional financial planning?

Paul Kaplan: What it does is it gives a complete picture of the financial situation of the investor. I think if you probably asked most people to draw a balance sheet, they would put in their mutual funds and their brokerage accounts and all that sort of thing on one side, and the other side, they put their mortgage or other liabilities that they have. And that's a very incomplete picture from an economic point of view because the investor is more than just those financial assets and liabilities. Human capital is a recognition that one of the most important assets that each of us has is the fact that we have a stream of income coming ahead of us from now and for the rest of our lives. And of course, when we're working that is mainly our salary, but even after we retire, we might have some kind of social insurance such as Social Security in the US or the Canadian Pension Plan here in Canada that we also need to count as income. And what do we do in economics? How do we look at a stream of future income and boil it down to one number? We fake the present discounted value. So that's what we do.

Now there's a question about what discount rate you should use, and we addressed it in the book, but that's the idea. Similarly, on the liability side, if we can look at all let's say our nondiscretionary consumption, we all need food, we all need clothing, we all need shelter, and we have to pay for these things. In our approach, we take the present discounted value of that spending, and we call that the liability. And so when we draw the economic balance sheet, on the asset side of the sheet are financial assets and human capital, and then on the right-hand side, we have the liabilities and then the difference between the left- and the right-hand side, which is called net worth. So, economic net worth is the best single indicator there is of what is still the financial state of an investor.

Christine Benz: Tom, how do enabling technologies like artificial intelligence change the calculus we might have formerly used to model human capital and does that have implications for how we build financial plans?

Tom Idzorek: Absolutely. When discussing AI, I like to differentiate between the latest hot flavor of AI that's in the news, generative AI, the use of these large language models, versus what I might call an expert systems type of AI. And so in the book, the models that Paul and I are advancing and developing involve simulation, optimization, probabilities, and different forecasting mechanisms. And I think of that as perhaps a form of an expert systems AI. From that perspective, I feel these traditional expert systems techniques provide us with a solid foundation for calculating human capital. Paul was just talking about discounting back at the appropriate discount rate. Where I see perhaps AI influencing is the calculation -- it's not really the calculation of human capital, it's more the description of it.

So, to the degree that we can already calculate that value. It's perhaps hard to explain what went into that calculation, what is human capital. What might alter somebody's human capital? I guess that's where I see what's going on with generative AI as being a fantastic device for taking a complicated subject and doing a better -- in fact, they'd probably do a better job of explaining than I'm doing right now. And so it's more how do you communicate to individual investors and advisors the concept of human capital, what is changing its value, how its value changes over time, and then what are the implications of human capital for how you should be investing the rest of your assets.