Stages of the Financial Life Cycle

In my last blog I introduced the economic theory and field of study of life cycle finance, a principal goal of which is to construct a useable framework to help individuals improve their financial decision making to produce better monetary outcomes and maintain the smoothest and highest possible standard of living throughout their lives.

A central construct upon which life cycle finance is based is that most individuals experience important lifetransitions each with different social, family, career and financial characteristics. The quality of the financial decisions they make during these periods will have significant and long-lasting implications for their finances.

The life cycle concept has been widely accepted by sociologists and marketers for decades and adopted as a useful framework to study and predict human development and consumption behavior. In contrast the adoption of financial life cycle theory has until recently remained in the realm of academic research and is only now becoming an accepted tool of personal finance practitioners.

Economists generally agree that a person’s financial life consists of six sequential stages, three of which occur during their working years and three more during retirement. Let’s look at each one briefly.

Early career – This is the start of a person’s financial life. Typically the priorities include paying down student loans, establishing an emergency fund, borrowing for the purchase of a car and perhaps a first home and launching a retirement savings and investment plan.

Career development and raising a family – The focus may be on upgrading career skills, improving earnings prospects, moving to a larger home, building a college fund for children, increasing insurance protection for the family’s breadwinners and accelerating retirement savings.

Pre-retirement and peak earning years – During this phase the financial needs of the family typically decline, career prospects level off and the emphasis shifts decisively toward retirement planning and preparation.

Active retirement –This period is often characterized by a desire to enjoy a busy lifestyle filled with travel, entertainment and other leisure activities. While individual spending patterns vary widely, many new retirees experience an increase in discretionary spending in order to pay for these activities.

Passive retirement- This is the stage when energy levels may begin to decline and health issues surface. Devoting more time to family and friends and staying closer to home becomes the preferred way to enjoy leisure time. Discretionary expenditures will likely decline only to be replaced by rising health care costs.

Elderly care – This phase is often marked by a significant decline in physical and mental capacity, a further reduction in vigorous activity and increased health and age-related expenditures.

To better understand human development and spending behavior researchers and practitioners in the fields of psychology, sociology and marketing have studied changes that individuals, couples and families exhibit over their lives. Not surprisingly patterns emerge at various ages and stages in life as people experience major life cycle transitions such as launching a career, starting a family, preparing for a departure from the workforce and then retirement and old age. Personal finance researchers and more recently financial practitioners have begun to make extensive use of these same approaches in studying how people do and perhaps more importantly should make the kinds of financial decisions that have far-reaching consequences for themselves and their families.