THE ECONOMIC BALANCE SHEET AND ASSET ALLOCATION
Last updated
Last updated
Learning Outcome
formulate an economic balance sheet for a client and interpret its implications for asset allocation
An accounting balance sheet reflects a point-in-time snapshot of an organization’s financial condition and shows the assets, liabilities, and owners’ equity recognized by accountants. An economic balance sheet includes conventional assets and liabilities (called “financial assets” and “financial liabilities” in this reading) as well as additional assets and liabilities—known as extended portfolio assets and liabilities—that are relevant in making asset allocation decisions but do not appear on conventional balance sheets.
For individual investors, extended portfolio assets include human capital (the present value of future earnings), the present value of pension income, and the present value of expected inheritances. Likewise, the present value of future consumption is an extended portfolio liability.
For an institutional investor, extended portfolio assets might include underground mineral resources or the present value of future intellectual property royalties. Extended portfolio liabilities might include the present value of prospective payouts for foundations, whereas grants payable would appear as conventional liabilities.
Theory and, increasingly, practice suggest that asset allocation should consider the full range of assets and liabilities—both the financial portfolio and extended portfolio assets and liabilities—to arrive at an appropriate asset allocation choice. For example, an asset allocation process that considers the extended balance sheet, including the sensitivity of an individual investor’s earnings to equity market risk (and that of the industry in which the individual is working), may result in a more appropriate allocation to equities than one that does not.
Life-cycle balanced funds (also known as target date funds) are examples of investments that seek to coordinate asset allocation with human capital. A 2040 life-cycle balanced fund that seeks to provide a retirement investment vehicle appropriate for many individuals retiring in 2040. Exhibit 3 illustrates a typical path for the composition of an individual’s economic balance sheet from age 25 through age 65.
Exhibit 3:
Human Capital (HC) and Financial Capital (FC) relative to Total Wealth
At age 25, with most of the individual’s working life ahead of him, human capital dominates the economic balance sheet. As the individual progresses through life, the present value of human capital declines as human capital is transformed into earnings. Earnings saved and invested build financial capital balances. By a retirement age of 65, the conversion of human capital to earnings and financial capital is assumed to be complete.
Life-cycle balanced funds reflect these extended portfolio assets. Research indicates that, on average, human capital is roughly 30% equity-like and 70% bond-like, with significant variation among industries.5 Making the simplifying assumption that investors have approximately constant risk tolerance through life, their asset allocation for total overall wealth (including human capital and financial capital) should be, in theory, constant over time. In this case, the asset allocation chosen for financial capital should reflect an increasing allocation to bonds as human capital declines to age 65, holding all else constant. Exhibit 4 shows the glide path for the equity/bond allocation chosen by one US mutual fund family. The increasing allocation to bonds is consistent with the view that human capital has preponderant bond-like characteristics.
Exhibit 4:
Glide Path of Target Date Investment Funds in One Family
Assumed Age
Equity Allocation
Bond Allocation
25
85%
15%
35
82
18
45
77
23
55
63
37
65
49
51
Source: Based on data in Idzorek, Stempien, and Voris (2013).
Although estimating human capital is quite complex, including human capital and other extended portfolio assets and economic liabilities in asset allocation decisions is good practice.6
EXAMPLE 3
The Economic Balance Sheet of Auldberg University Endowment
Name: Auldberg University Endowment (AUE)
Narrative: AUE was established in 1852 in Caflandia and largely serves the tiny province of Auldberg. AUE supports about one-sixth of Auldberg University’s CAF$60 million operating budget; real estate income and provincial subsidies provide the remainder and have been relatively stable. The endowment has historically had a portfolio limited to domestic equities, bonds, and real estate holdings; that policy is under current review. Auldberg University itself (not the endowment) has a CAF$350 million investment in domestic commercial real estate assets, including office buildings and industrial parks, much of it near the campus. AUE employs a well-qualified staff with substantial diverse experience in equities, fixed income, and real estate.
Assets: Endowment assets include CAF$100 million in domestic equities, CAF$60 million in domestic government debt, and CAF$40 million in Class B office real estate. The present value of expected future contributions (from real estate and provincial subsidies) is estimated to be CAF$400 million.
Liabilities: These include CAF$10 million in short-term borrowings and CAF$35 million in mortgage debt related to real estate investments. Although it has no specific legal requirement, AUE has a policy to distribute to the university 5% of 36-month moving average net assets. In effect, the endowment supports $10 million of Auldberg University’s annual operating budget. The present value of expected future support is CAF$450 million.
Prepare an economic balance sheet for AUE.
Solution to 1:
The economic balance sheet for the endowment (given in the following table) does not include the real estate owned by Auldberg University. The economic net worth is found as a plug item (600 − 10 − 35 − 450 = 105).
AUE Economic Balance Sheet (in CAF$ millions) 31 December 20x6
Assets
Liabilities and Economic Net Worth
Financial Assets
Financial Liabilities
Domestic equities
100
Short-term borrowing
10
Domestic fixed income
60
Mortgage debt
35
Class B office real estate
40
Extended Assets
Extended Liabilities
Present value of expected future contributions to AUE
400
Present value of expected future support
450
Economic Net Worth
Economic net worth (Economic assets − Economic liabilities)
105
Total
600
600
Describe elements in Auldberg University’s investments that might affect AUE’s asset allocation choices.
Solution to 2:
AUE’s Class B real estate investments’ value and income are likely to be stressed during the same economic circumstances as the university’s own real estate investments. In such periods, the university may look to the endowment for increased operating support and AUE may not be well positioned to meet that need. Thus, the AUE’s real estate investment is actually less diversifying than it may appear and the allocation to it may need to be re-examined. Similar considerations apply to AUE’s holdings in equities in relation to Auldberg University’s.
