Protecting our human capital

In my last blog post, I talked about the risks we face in our financial lives. Managing financial risks starts with identifying them, determining what could go wrong and how bad things could get.  Only then we can construct a risk management plan to protect against potentially catastrophic events.

The theory, known as “lifecycle finance,” explains how individuals and families can maximize their standard of living by making smart financial decisions during the various phases of their lives. The central concept is the distinction between two types of wealth, human capital, and financial capital.

Our last discussion focused on human capital, our future earning potential. This week concentrates on financial capital, the amount of net assets, after paying off debts, we have already accumulated and are available to support us in the future.

The difference between what we own (assets) and what we owe (debts), is a measure of our wealth known as net worth or in the vocabulary of lifecycle theorists, financial capital. Risks to financial capital abound and can come from both outside and within our families.

External threats can come in the form of substantial losses to our property, primarily our homes and valuables, due to thefts, fire, and other hazards. The simple solution is homeowners insurance with sufficient coverage to rebuild your home given current costs of building materials and labor and replace its contents.

The greatest external threats, however, are from liability claims arising from property damage, or worse, personal injury (i.e. bodily injury and pain and suffering) to other parties. Without adequate protection, a single event can shatter a family’s financial security. Fortunately, these are insurable risks. Adequate homeowners, auto, personal umbrella, and when warranted, professional liability insurance, is a necessity, not an option. Additionally, special riders or policies may be needed to cover specific risks such as swimming pools, water vehicles, household workers, and others.

Employer 401(k) type plans and IRAs are the single largest component of most families’ financial capital. Although these two retirement savings vehicles share similarities, they differ substantially in the shelter afforded against creditor claims. Most employer retirement plans are covered by the federal Employee Retirement Income Security Act (ERISA) and provide broad protection from creditors. Protections for IRA assets, on the other hand, are more limited and depend upon several factors including your state of residence and the source of the IRA assets. Understanding the nuances of federal and state laws that apply to your situation can prevent an innocent but potentially costly misstep, including rolling over or mixing assets from one type of account to another.

The most likely and potentially dangerous threat to a family’s wealth comes from within. No parent wants to leave an inheritance only to have it later lost in a divorce. The high incidence of multiple marriages and divorces make this scenario increasingly probable, especially when several heirs are involved. Although there are no absolute ways to protect an intergenerational transfer of assets from this risk, a variety of relatively simple trusts has proven effective in providing at least some measure of protection.

No matter how well we prepare, the future is beyond our control. No one can predict the risks we will face, but we can prepare for those we may face. Most people will become motivated to act only after they experience a crisis, but by then it may be too late. The smarter ones will take action during more predictable periods with a clear head and devise a risk management plan that includes the right balance of smart lifestyle and career decisions, along with insurance, asset, and estate planning. The odds are good that such a plan will allow you to enjoy a fuller life with greater peace of mind.