Total Wealth: Financial Capital & Human Capital

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The wealth of an individual is often assessed in terms of assets that can be bought, sold, loaned, borrowed, and exchanged. While physical and financial assets do represent a proportion of an individual’s wealth, an accurate assessment of an individual’s total wealth must also consider human capital.

What is an Individual’s Total Wealth?

At any point in time, an individual’s total wealth should be represented as the sum of their financial capital and human capital.

What is Financial Capital?

In this context, financial capital is defined as assets under the control of an individual that can be readily sold or exchanged, less any financial obligations owed by the individual. This is commonly referred to as a person’s net worth.

The calculation of financial capital includes the sum of assets like physical currency, the contents of checking/savings accounts, retirement accounts (401k, IRA, Roth IRA, etc.), brokerage accounts, real estate, precious metals, collectibles, and many other types of salable assets. The financial obligations subtracted from the sum of assets includes any debt – or any proportion of a debt – that an individual is personally responsible to repay.

What is Human Capital?

Human capital is the present value of an individual’s expected lifetime employment-related income. The pertinent income is described as employment-related because Social Security retirement benefits and defined benefit pensions are typically included in this calculation. These sources of income are not immediately attributed to a recipient as compensation for specific acts of employment, but the value of benefits accrued are typically associated with the amount of an individual’s employment income and participation in the labor force over time.

In contrast to financial capital, human capital has traditionally been regarded as non-tradable.* Although lacking tradability, human capital is also generally accepted to represent a tremendous proportion of the average individual’s total wealth over the course of their life.

Considering the personal saving rate and reports on economic well-being in the U.S. – both reflecting the conversion of human capital into financial capital – the idea that human capital might be the largest component of the average individual’s total wealth across much of their life is not difficult to imagine.

How is Human Capital Calculated?

Human capital at a given age is calculated as the sum of the present values of all subsequent expected periodic employment-related income across an individual’s life expectancy. The present value of each period’s income is calculated as an individual’s inflation adjusted expected periodic income, discounted for the appropriate number of periods at a rate suitable to the riskiness (uncertainty) of an individual’s employment-related income.

In general, the higher the expected variance of an individual’s future income, the higher the discount rate that should be applied. This is because, if a specific amount of future income is expected to be realized within a small margin of error, each dollar of that income should be worth comparatively more today than income that is expected to be realized within a larger margin of error.

For example, the average teacher can often predict what their income will look like over the course of their career with much smaller deviations from expected income than the average professional athlete. In terms of the present value of future income expected, the teacher’s income (on a dollar-for-dollar basis) should be worth more today than the professional athlete’s future income, which might be much less likely to materialize. This is not dissimilar to how discount rates are utilized in their application to some financial assets, like stocks and bonds.

Historically, stocks, as an asset class, have produced larger variance among periodic returns than, say, the government bonds of developed economies. With greater uncertainty of future value than some government bonds, the present value of stocks are adjusted to reflect the heightened risk of not achieving expected values by applying a comparatively higher discount rate than bonds.

Being as difficult as it is to properly identify, the appropriate discount rate for human capital is often borrowed from or influenced by financial assets. When a correlation is assumed or known between the periodic income of a given profession and a class or category of financial asset, the discount rate associated with a specific financial asset is sometimes modified to provide a basis for establishing a suitable discount rate for employment income.

Although the human capital of the average individual is believed to have a low correlation with aggregate equity markets (Davis & Willen 2000), the use of securities-influenced discount rates may be appropriate for specific individuals. This is, perhaps, most true for individuals earning employment income related to sources highly susceptible to specific economic shocks.

The choice of discount rate utilized can have an outsized impact on the calculation of human capital; especially for a young person, for whom the discount rate chosen will compound over many years. Because determining the appropriate discount rate is somewhat difficult, establishing a precise and reliable value for human capital over extended periods is unlikely.

It is critical to recognize that it is not necessarily the accuracy of the calculation that is the most important reason to include human capital in the assessment of total wealth. Rather, the consideration of factors necessary to perform the calculation provide insight that might beneficially affect the construction of an individual’s financial plan and investment portfolio allocation.

Human & Financial Capital Across Time

Ideally, an individual’s realized human capital will be converted, in part, into financial capital over time. This transfer creates a tradeoff by which, at the beginning of one’s career, their human capital represents around 100% of their total wealth, and, by retirement, their financial capital might represent 70-90% of their total wealth (pension and Social Security retirement benefits making up the remaining 10-30% of total wealth).

Charts comparing total wealth over time as financial and human capital

The charts above both assume that the hypothetical individuals begin working at age 23 with $30,000 in student loan debt, save 10% of their expected annual income (adjusted annually for inflation at 3%), invest it at an average annual rate of 5.5%, and retire at age 66. Post retirement, both charts assume that the individuals will begin distributing 4% of their financial capital to themselves annually, while continuing to earn an average annual rate of 5.5% on their remaining financial capital, until the end of their life expectancies at age 95.

The only differences between the two charts are the starting incomes and the discount rates utilized to calculate the present value of the two incomes. The lower/less risky income chart utilizes starting income of $38,000, and a discount rate of 3%, reflecting a virtual guaranteed receipt of the expected income. The higher/riskier income chart utilizes starting income of $75,000, and a discount rate of 7%, reflecting an income that is sensitive to changes in the broader economy.

The charts illustrate how the human capital of an individual with higher/riskier income could initially be much lower than that of an individual with lower/less risky income. As time passes, and human capital is realized (received as income), the individual with higher/riskier income is able to convert larger amounts of human capital into financial capital, and their total wealth is eventually expected to exceed that of the individual with lower/less risky income.

Benefits of Considering Human Capital

The proportion of an individual’s total wealth represented by human capital is frequently little more than a thoughtful estimate. The process of trying to determine this thoughtful estimate, however, can uncover valuable information.

By attempting to quantify one’s human capital, details such as the correlation of one’s income to various economic factors, as well as financial assets, can become better understood. This information might help an investment manager create an investment portfolio that more realistically reflects the overall risks to one’s economic security.

From a financial planning standpoint, examining one’s human capital can help determine the appropriate amount of life insurance that one should maintain at different stages of their life. On the other end of the planning spectrum, exploring human capital can also help individuals better understand issues associated with longevity risk.

Although the end result is material and important, the true benefit of considering an individual’s human capital might be more about what is gleaned throughout the discovery process than the value of arriving at a specific number. If nothing else, failing to consider one’s human capital could diminish the efficacy of a financial plan, and lead to an improperly allocated investment portfolio.



*Is human capital tradable? As recently as a century ago, indentured servitude was a common means for individuals to trade their human capital, in the form of labor over a prespecified period of time, in exchange for transport, meals, and shelter. Today, income-share agreements (ISAs) allow some college students to directly exchange a portion of their potential human capital for financial capital. As unsettling as this exchangeability of human capital might seem, it further justifies the need to consider human capital as a legitimate component of total wealth.

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