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.

The Retirement Crisis Next Door – Part Two

In my last blog post, we talked about why many Americans are not prepared for retirement. In the new book, “Falling Short: The Coming Retirement Crisis and What to Do About It” (Oxford University Press), authors Charles Ellis, Alicia Munnell and Andrew Eschtruth offer a historical perspective on retirement, including the shift from retiree pensions and health plans to less generous benefits for today’s workers. Unfortunately, Americans will almost certainly feel the impact on a second front.

Social Security and Medicare, two programs that provide a critical safety net for millions including upper-middle income retirees face large and growing shortfalls. Left unchecked, they will be unable to pay the benefits that have been promised. While lawmakers have thus far been unwilling to tackle the problem, eventually they will be forced to. It is difficult to envision a solution that does not include a combination of benefit cuts, higher taxes, and increased eligibility age. The net result is that workers and retirees will receive less from these programs and pay a greater share of their expenses out of savings. Those who fail to account for a material reduction in government benefits in their planning may be headed for an unpleasant surprise.

In pursuit of economic security once the paychecks stop, investors face yet another challenge: since the early 1980s interest rates have been on a steady decline. While in the short-term declining rates can be a positive for stocks, over extended periods, it often translates into lower stock returns. For workers, lower future returns for both bonds and stocks means they will need to save more to accumulate the nest egg they need. For retirees, it means that their nest eggs will produce less income.

The new reality. Americans will receive less guaranteed income and health care coverage from employer and government sources at a time when longer lives, escalating health costs and lower expected investment returns will require more assets to pay for living expenses. Workers and retirees will shoulder an unprecedented degree of the responsibility and risk to save enough and invest sensibly to ensure their retirement security. There is little debate about the reasons. These trends will only increase over time. Unless big changes are made, retirement preparedness will decline with each successive generation. Fortunately, this problem is solvable. In “Falling Short” the authors suggest a multi-faceted approach involving workers, employers, and government policy makers.

First and foremost, Americans need to save more, a lot more. One option is for households to cut consumption and increase savings each year. For many families, however, who are confronted with competing priorities of raising a family, paying for daycare and planning for college tuition, this may be tough to pull off. Saving for retirement usually takes a backseat. The other option is to stay in the workforce longer. Common sense tells us that if we are living longer and our general health is better than previous generations we can continue working longer. There may be no better way to improve financial security in retirement. Research and basic math support this idea. For many older Americans, deferring retirement by just a few years can have a big impact for several reasons. The few extra years of work allows a household to increase retirement plan balances, rely on those balances to fund fewer years of leisure, and collect a bigger check from Social Security. Wharton professor Olivia Mitchell suggests, “For the younger generation age 75 might be a good target for early retirement and later if possible!”

We know that left to their own devices, not all workers will participate in an employer’s retirement plan, and those who do save less than they should and make poor investment decisions. As such, employers can play an instrumental role in addressing these shortcomings by adopting some simple measures that have become accepted best practices for 401(k) type plans. These measures are automatic enrollment, automatic escalation, easy to understand investment choices and minimal investment costs. Auto-enrollment increases the number of employees who participate in the plan, and auto escalation increases the amount each employee contributes annually. Both turn the powerful psychological resistance to change, known as inertia, to a behavioral benefit. Simplifying investment options avoids mental gridlock by employees, so they are more likely to make better choices. Low-cost investments improve the odds of better returns. Combined, these simple policy changes have been shown to deliver big benefits to employees in the form of larger account balances.

As unpalatable as it may be to certain blocs of voters, lawmakers have a duty to implement the changes necessary to ensure that Social Security and Medicare remain viable. Policy-makers should also further simplify the process for small employers who want to offer tax-advantaged retirement plans to employees but are intimidated by the complexity and cost.

Economic and demographic change has transformed the retirement landscape. To meet the challenges this presents, we as individuals, employers, and a nation will need to adapt as well. Most importantly, smart Americans will face up to this new reality by adjusting their plans now, spending less and saving more.

The Retirement Crisis Next Door – Part One

Since the 1950s academic and financial industry researchers have developed an impressive literature on the financial readiness of American workers for retirement. The general conclusion is that a large number of Americans across a broad swath of the income spectrum is poorly prepared.

In their powerful new book “Falling Short: The Coming Retirement Crisis and What to Do About It” (Oxford University Press), authors Charles Ellis, Alicia Munnell and Andrew Eschtruth present the nature and magnitude of the problem. Ellis, a former consultant to some of the world’s most sophisticated financial institutions and Munnell and Eschtruth, Boston College public policy experts, deliver a message that is straightforward and not especially upbeat; “Because of economic and demographic developments, our retirement income systems are contracting just as our need for retirement income is growing. On the income side, Social Security is replacing less of our pre-retirement income; traditional defined benefit pension plans have been displaced by 401(k)s with modest balances; and employers are dropping retiree health benefits. On the needs side, longer lifespans, rising healthcare costs, and low-interest rates all require a much bigger nest egg to maintain our standard of living. The result of all of these changes is that millions of us will not have enough money for the comfortable retirement that our parents and grandparents enjoyed.”

In the United States and much of the developed world, retirement is a much-anticipated event.  It represents a time in life that offers greater independence, more time for leisure, family, friends and personal fulfillment. So why do so many Americans find themselves unprepared? The newness of the problem may be the main reason. A brief historical perspective offers some insight.

A 20th century invention. The idea of a period of leisure after three or four decades of working is a relatively new concept in human history. Up through the early 1900s people typically worked until they were physically unable and often passed away shortly thereafter. During those interim years, if they required assistance, family members who usually lived close by, cared them for.

The glory days. During the period from the mid 1930s through the mid 1980s, four significant developments established what is nostalgically referred to as the “Golden Era” for American retirees. First, the Social Security Program was created to provide income for life for retired American workers. Second, the employer-based pension movement that had begun in the late 1800s and also offered a lifetime income stream to retirees began to expand rapidly. Third, to protect older retirees without access to an employer’s health plan against catastrophic medical expenses, Medicare was created. Additionally, some private employers extended subsidized health insurance benefits to retirees, further reducing their out-of-pocket costs. The rich benefits were affordable to employers and the federal government because not many people lived long enough to claim them for more than a few years. The safety net for the elderly had never been stronger. The impact of two powerful forces had yet to be felt.

The seismic shift. The 1990s began a transition from the “Golden Era” to what workers and retirees face today. The two driving forces were the remarkable increases in human longevity and escalating health costs. The advances in technology and medicine that was largely responsible for both of these factors showed no signs of abating.

It didn’t take long for companies to appreciate the implications. Baby boomers and succeeding cohorts that would be leaving the workforce in droves were likely to remain retired for a very long time. Pension and health plans in their current form were designed to support retirees for a period of years, not multiple decades. Private employers have responded by shifting away from defined benefit pensions to 401(k) type plans; offering less generous health insurance plans for workers and sharply curtailing or eliminating those for retirees. These trends have continued to accelerate. According to the American Academy of Actuaries, “In 1980, 84% of workers in medium and large organizations were covered by defined benefit plans. In 2010 only 30% were. A 2014 Kaiser Family Foundation study reported that “since 1988, the percentage of large (the study’s authors define as 200 or more employees) firms offering retiree health coverage has dropped by more than half from 66% in 1988 to 28% in 2013.”

Employer sponsored benefits are not the only casualties of increasing lifespans and steadily rising medical costs. Americans will almost certainly feel the impact on a second front. In my next blog post, we will discuss the effects on two of the most important programs workers count on for a secure retirement.