At the height of the economic and market boom, a friend on a defined benefit pensionable job in the government was being wooed by several firms in the financial sector. This was before the Pay Commission and he took home all of a quarter of a lakh each month. The move to the private sector would simply add a zero behind that amount. Plus perks, of course.
His dilemma was this: his base level service years were not completed, making him ineligible for pension if he quit the government now. The private employer he was comfortable joining was unwilling to wait for the two years left in his service, but was willing to offer a joining bonus, that if invested, would make good a part of that pension foregone.
It was a textbook problem of having to decide which road one would like to choose. On one side is current wealth, that if invested will provide future security. On the other is the comfortable cushion of a safe job, great work-life balance and the joys of being in government.
At that point, when he did not know the future—Lehman had not collapsed, markets were at 18,000 and, more importantly, the Pay Commission was still just talk—to take a call like this, with kids to put through higher education, gave him sleepless nights.
Recently, while browsing through a book called Are You a Stock or a Bond?: Create Your Own Pension Plan for a Secure Financial Future by Toronto-based finance professor Moshe Milevsky at the York University’s Schulich School of Business, I saw that friend’s story in the title. The book looks at a human lifetime as a process of converting human capital into wealth, both financial and real. When you start out, the value of the human capital is very high, though the wealth value is low. At mid-life, you are halfway through your human capital, but should have assets that show the result of the last 20 years of use of this human capital. At 65-70, the human capital’s ability, or desire, to convert itself into wealth is low and this is the point at which the wealth capital should be enough to take the human vehicle to the final workshop. Life insurance fits into this paradigm as the vehicle that the family switches to, if something were to happen to the wealth-generating human capital halfway through the journey. The case for a low-cost term insurance plan becomes even more obvious when we look at the world through Milevsky glasses. Sounds terribly cold-blooded, but it’s true.
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As a step two, the book asks you to figure out if you are a stock or a bond. You are an inflation-indexed bond if you are in a defined benefit pension plan and in a job that is not subject to the free market hire and fire drill. You are non-blue chip stock if most of your income comes from variable pay and is performance-based. As an employee of a large firm with a good track record of HR practices, you are a relatively low risk blue chip stock on the risk-return continuum. Now, what financial products you buy will depend on who you are. A bond is on a very firm footing financially and should be buying equity to increase this wealth capital. A stock is already in a high risk zone and should be skewed more towards bonds to reduce the risk in his life. The more like a stock you are in your income flows and job security, the lesser is your allocation to equity. This is asset allocation at a totally different level and makes the investing decision much simpler for an individual.
Financial planners the world over have been searching for the holy grail of asset allocation—is there a golden rule that works? I think Milevsky’s work takes the debate forward in an innovative way. The friend’s fork in the road was this: should he trade his entity as a gilt-edged bond to become a stock on the far side of the risk-return curve? Believe me, the decision is not easy. The sudden increase in lifestyle today versus the safety net of the future. What would you have done?
Back to my friend. It is now almost three years to that debate. Friend took a call and decided he is Mr Bond. He is still with the government. The Pay Commission happened. Markets collapsed. The firm that he was considering joining folded up. And his wife took VRS and moved to the private sector and earns a bomb. Um. Some people are just lucky.
Monika Halan is a certified financial planner and is currently working as adviser, Pension Fund Regulatory and Development Authority. Your comments and personal finance queries are welcome at firstname.lastname@example.org