Life cycle theory is one of the more exciting and useful areas of research in personal finance. In broad terms, it represents the body of economic theory and knowledge that examines how individuals can make wiser and more beneficial decisions about spending, saving, investing and insuring over their lifetimes. There are several concepts underlying life cycle theory. We’ll discuss two of them in this article.
First is the premise that individuals will be making decisions about how to manage their wealth across a planning horizon that can span 60 years or more. This period begins at the start of a career at age 25 until the end of retirement at 85 or older and includes different life phases. The second assumption, derived from the field of classical economics, presumes that people are rational, have a firm grasp on self-control. Therefore, they will deploy their income and assets in a way that will enable them to maintain the smoothest and highest possible standard of living throughout their lives. This concept is known as “consumption smoothing”.
For example, following the consumption smoothing framework, a person might make a series of spending, saving, investing and insuring choices that allow them to maintain inflation-adjusted spending of $75,000 per year over their entire life. This is presumed to be preferable to a series of financial decisions that result in a $95,000 per year standard of living during their working years but only $55,000 during retirement or vice versa. The rationale behind this concept is intuitive. Given the option, most people would not choose to live an opulent lifestyle while they are working and then because they have failed to save enough, be forced to live frugally in retirement when they have more time to enjoy themselves. Conversely, they also wouldn’t want to live an unnecessarily frugal life throughout their careers in order to enjoy a lavish lifestyle that they may be unable to enjoy in retirement. In short, the main goal of life cycle finance is effectively to distribute a person’s income from the working and earning years over their entire life.
In theory, in order to accomplish this goal, individuals would borrow early in life when income and assets are low and needs are high. This would include paying for college, buying a car and purchasing a first home. Later in life when income is rising and basic individual and family needs have been satisfied, saving becomes important in order to fund the later years when they leave the workforce and rely on those assets to supplement Social Security, employer pensions and other income. That’s the theory. But as 20th-century philosopher and Yankee Hall of Famer, Yogi Berra has been attributed as saying, “In theory, there is no difference between theory and practice, but in practice there is.” In a computer model, applying consumption smoothing is relatively straightforward. In real life, however, many of the important financial choices we face are shrouded in uncertainty and fraught with risk. For instance, we can’t predict with accuracy the length or trajectory of our career earnings, the financial needs of our families, the returns we will earn on our investments or how long we will live in retirement.
In future posts, we’ll look at ways the average investor can use the life cycle model to make better financial decisions and improve the economic outcomes for themselves and their families.