What is Life Cycle Finance?

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.

Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.

Compound Consequences

Underestimating the impact of compound growth on a household’s finances can lead consumers to make poor economic decisions including borrowing too much and saving too little. There are three main engines that drive compound interest on an investment made or a loan taken out. They are the amount invested or borrowed, the time horizon of the investment or loan, and the interest rate earned or paid. The longer the time horizon and the higher the growth rate, the greater the financial impact.

Most major financial decisions such as saving for retirement or repaying a loan involve large dollar amounts, long time periods and relatively high growth rates. Therefore, compound growth can have an enormous effect on an individual’s financial security. Even modest amounts saved can turn into substantial retirement nest eggs and small amounts borrowed can spiral into large debts over time. Read more