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 Cost of Retirement

Retirement is expensive. How much money you will need each year when you stop working depends on your individual circumstances and the kind of lifestyle you expect to live. Your estimate will be the starting point of your retirement plan and will drive many of the other planning decisions you make, including those regarding Social Security benefits, your retirement date, and how much you need to save in the interim. There are two ways to arrive at this important number.

The most popular method is called the Income Replacement Ratio. It is the percentage of your working, pre-tax income needed to maintain your standard of living in retirement. It is based on industry and academic studies of retirees and generally indicates that most seniors need between 70 percent to 90 percent of their pre-retirement income. The assumption being that income and FICA taxes, and retirement savings contributions that consume 10 percent to 30 percent of a person’s income, will be reduced or end in retirement. It also assumes that work-related expenses that decrease in retirement will be offset by expenses such as health care that will likely increase. For example, if you have an annual gross (pre-tax) income of $50,000 before retirement, using the 90 percent rule of thumb would indicate you will need $45,000 per year in retirement. Read more

No time like today to save for tomorrow – Part 2

In my last post, I talked about the importance of making good financial decisions when planning for retirement. Although people have good intentions about how and when to save, left to their own devices, they fall prey to certain biases when making financial decisions. In this article, we’ll address additional obstacles and introduce some solutions to work around these issues.

Procrastination. Closely associated with self-control, procrastination is the tendency to postpone unpleasant tasks. Instead of engaging in a goal-achieving activity such as retirement planning that involves complexity and may lead to frustration, people often opt for a stress-relieving activity such as watching a favorite television program. Herbert Simon, another Nobel Laureate related procrastination to “cognitive laziness” which is the attempt by individuals to avoid the hard work of thinking through a problem.

 Inertia. Procrastination in turn produces a related psychological force known as inertia, which is the resistance to change. This resistance often is the consequence of what is known as “loss aversion”. This is the tendency of decision-makers to put more emphasis on what they could lose rather than how they might benefit. A key finding of behavioral economics is that people weigh losses significantly more heavily than gains. Some estimates peg the ratio at 2:1. In other words, losses generate twice as much psychological pain as gains yield pleasure.

Loss aversion affects saving decisions because once households become used to a particular level of take-home pay, they tend to view reductions in that level as a “loss”, even when it is the result of increased savings. Compounding the challenge, saving for retirement involves a difficult trade-off between current and future consumption. The evidence is clear that most individuals have a strong preference for the immediate rewards of spending today over the future payoff of enjoying an increased standard of living in retirement.


Fortunately, the study of the behavioral forces that result in poor decisions has enabled researchers to develop strategies to employ those forces to produce better choices and financial outcomes. A program designed by behavioral economists Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago does just that. Their program called Save More Tomorrow (SMarT) is intended for employers who want to increase employee savings rates in 401(k) type plans. One feature known as “automatic escalation” however can easily be adapted by the average person saving for any important future goal.

The idea is to automatically increase savings from the employee’s paycheck with each future salary increase. This simple tactic can avoid the psychological barriers that impede individuals from achieving what they want; minimum pain today and larger account balances at retirement. It uses what could be considered a “behavior first” approach meaning that it requires a change of behavior rather than a change of attitude or an increase in computational skills. These are some of the benefits:

  • It’s simple. It eliminates the complexity of making difficult assumptions and calculations. It is a yes or no decision. You either commit to it or you do not. Once committed, you know that 30%, 50% or more of each pay increase will be “swept” into an investment account. All of the calculations are complete, and the hard work is done.
  • It is pre-determined. Because of the psychological barriers of lack of self-control and procrastination, most of us find it easier to imagine and commit to doing something difficult in the future rather than right now. Pre-commitments are a way of avoiding the inevitable temptation of the moment (when the cash is in our hands), and our inclination to procrastinate matters that have an immediate cost but a future reward.
  • It’s painless. Inertia can be triggered by several factors, one of which is hypersensitivity to loss, or placing more weight on the pain from the potential loss than the benefits from the potential gain. In the savings context, people hate to see their take-home pay go down. The automatic increase program does an end-run around these powerful psychological forces. In their book “Nudge” authors Richard Thaler and Cass Sunstein applaud the success of the SMarT program in general and the automatic escalation feature specifically. “By synchronizing pay raises and savings increases, participants never see their take-home amounts go down, and they don’t view their increased retirement contributions as losses. Once someone joins the program, the saving increases are automatic, using inertia to increase savings rather than prevent savings.” Simply put, it is easier to keep on doing what you have been doing, than it is to change.

Behavioral economists have identified the obstacles humans face when making financial decisions involving complex problems surrounded by uncertainty and require an immediate sacrifice for an uncertain payoff in the distant future. That is to say, precisely the elements households face in planning for retirement. As humans, we fall prey to a combination of psychological forces that lead us to make poor choices.

Fortunately, the same factors that hinder individuals from making wise choices are now being employed to help people improve their chances of securing a comfortable retirement. Committing to save a substantial portion of future pay increases is one of the simplest and most effective strategies to do this. It does not require superior skills or an advanced degree, just a little common sense – and yes, also some self-control.