Human capital and investing in employee stock benefits

Today I would like to introduce the concept of human capital and briefly touch on employee stock purchase program.

What is human capital?

Human capital is simply the ability to earn money by working. If you earn $5000 a month and has 30 more years of working life, the human capital is 5000 x 12 x 30  = $1.8 million assuming no pay increment and inflation is zero.

Because the human capital is the ability to earn money, it is beneficial to increase this human capital as high as possible. Possible ways of increasing human capital are:

• Increasing the working period. By extending the retirement age, human capital increases. (A young graduate has a very high human capital simply because he is young. However, there is no way for a person to become younger since time machine is not yet invented.)
• Good education. It is well known that there is a high correlation between education and human capital. The more educated a person is, the higher the human capital.
• Relevant skill. The more skilled a person is, the higher the human capital as compared to another person with less skills - all things equal.
• Relevant experience. A person who is more experience in a well sought after field, the higher the human capital.

Human capital will decline or even suddenly become zero when:

• One approaches retirement age.
• Disability or death resulting in permanent loss of income.
• The occupation becomes obsolete (e.g. replaced by robots, cheaper sources of labor).

Because human capital is so important, it has to protected. The usual way of protecting human capital is by buying life insurance. Those who do not believe in buying life insurance is effectively saying they are not concern with their own human capital. To ensure the human capital is not wipe out due to occupation irrelevance, it is important to constantly upgrade through education and skill upgrading.

What is financial assets and its relationship with human capital?

Financial assets are simply cash, property, bonds and stocks.

When a person is young, he or she has very little financial assets. However, the human capital is large. As time goes by, the human capital decline (because the remaining working years decreases) but the financial assets increase provided the individual save and invest his surplus cash flow.

When a person is retired, his human capital is at the lowest. His financial assets should be the highest. However, the financial assets start to decline as he starts to deplete it because of the lack of active income.

Below is a chart to illustrate the relationship between human capital and financial assets:

Financial planning is about protecting the human capital, budgeting (to ensure the active income is not all spent away), wealth accumulation to increase the financial assets and wealth monetization which is the depletion of assets during the retirement phase.

The investment portfolio

In investment, we usually just consider the financial assets in the portfolio. However, a more holistic approach is to include the human capital as part of the portfolio. For example, the portfolio of a 35 years old person may look like:

Human capital - $1,400,000
Financial assets - $400,000
Total: $1,800,000

As in any prudent investment, we want to make sure we diversify the portfolio by ensuring the portfolio invests in low correlated assets. If the human capital is considered as an asset, it is important to ensure the human capital has low correlation with the financial assets. With this in mind, the following are general rule that should be followed:

1. A person with an ‘iron rice bowl’ (e.g. stable job) can consider a higher risk investment since the human capital and investment has low correlation.
2. A businessman should not invest in companies of the same industry as his own business otherwise the correlation is too high.
3. A stock broker should invest more in bonds since his income has an equity like volatility.
4. An employee should not invest in his own employer. This brings me to the next section:

Stock employee purchase program

It is common for multinational companies to offer stock employee purchase program. Such a program comes with various permutations such as:

1. Stock options. This gives the employee the right but not the obligation to purchase the company stock at a certain price called the strike price.
2. Share purchase. This gives the employee the chance to purchase the company stock at a discount. Normally this is compulsory.

Such stock program usually has a vesting period which is like a waiting period. If the employee leaves the company within the waiting period, all his stock benefits will be forfeited.

It is quite common for employees to accumulate a very large amount of money investing in their own company due to 3 main reasons:

1. Due to the vesting period, it creates a sense of holding the stock for a long period to the extend the employee no longer wants to sell the stock. We call such an effect the status quo effect.
2. If the employee is happy and familiar with his employer, he would naturally not mind holding a large position in the company stocks. This is known as the familiarity effect.
3. But due to the familiarity effect, he ends up subjecting himself to the overconfident effect.

The status quo effect, familiarity effect and overconfident effect are well documented irrational behavior in the world of finance (i.e. these are not my inventions).

That day, I came across a client who had a total financial asset of $800,000. However, $250,000 were invested in his own company shares and all the shares were vested already. I told her to sell all the company shares but she refused due to the status quo effect, familiarity effect and overconfident effect.

It is not wise to invest in the employer’s company shares due to the perfectly positive correlation between the human capital and the performance of the share price.

To give a simple illustration. Let’s say the employer suffer poor earnings, the stock price would drop and the employee could suffer a pay cut or even get retrench. Hence, both human capital and share price suffers at the same time. Is this possible? Remember Enron that collapsed in the early 2000s? Not only did their employees loss their jobs but their retirement savings were devastated because they heavily invested in their own employer's share. See Employees' Retirement Plan Is a Victim as Enron Tumbles.

A more recent example is Lehman Brothers. See Lehman employees lose appeal over stock losses from bankruptcy

Estate planning issues with employee stock benefits

Companies that are generous in employee stock benefits are normally very large companies. If these companies are listed in United States, there will be tax implication.

Consider a person with a human capital of US$1,400,000 and US$400,000 invested in his own employer which is listed in the United States.

Upon his demise, the estate duty is 40% * (400000 – 60000) = US$136,000.

Since he dies, his human capital is a total lost.

Thus, his estate becomes 400000-136000 = $264,000. Imagine a total asset of $1.8 million becomes $264,000. This is terrible.

Conclusions

1. A person with an ‘iron rice bowl’ (e.g. stable job) can consider a higher risk investment since the human capital and investment has low correlation.
2. A businessman should not invest in companies of the same industry as his own business otherwise the correlation is too high.
3. A stock broker should invest more in bonds since his income has an equity like volatility.
4. An employee should not invest in his own employer. Sell these shares as soon as the vesting period is over.

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