Smoothing the Path: Balancing Debt, Income, and Saving for the Future

Consumption Smoothing

The “life cycle” theory of consumption and saving was pioneered by Franco Modigliani, winner of the 1985 Nobel Prize in economics. The theory is a common model used by economists to describe people’s overall saving and spending behaviors. Most people’s lifetime income follows a hump-shaped pattern: Income is lower when they are young, income rises (and peaks) during middle age, and income falls again during retirement. If consumption matched income, then consumption would have a hump shape as well. That is, people would consume few goods and services when they are young, consume a great deal when middle aged, and again consume very little after they retire. However, in reality, most people prefer a smoother consumption pattern over their lives, as shown in the first figure (below).

Figure 1: A Model of Saving and Spending: The Life Cycle Theory of Consumption and Saving

NOTE: The life cycle theory of savings suggests that people prefer smooth consumption over their lifetime. Workers can smooth their consumption by borrowing while they are young, saving in middle age, and "dissaving" during retirement.

When people are young, they make up the difference between their preferred consumption and their relatively low income by borrowing. For example, this allows (i) students to go to college using college loans and (ii) new workers in the labor force to buy housing using mortgage loans. During middle age, income rises above preferred consumption, and the model suggests that people limit current consumption to pay off student loans and mortgage debt (among other debt) and save for retirement; this is the accumulation or saving phase. During retirement, when income falls, people dissave by spending their retirement savings. Thus, both borrowing and saving help smooth consumption over time.

The life cycle model assumes that people prefer smooth consumption over time, can reasonably estimate their income, and can plan their savings and consumption patterns to achieve a smooth consumption pattern over decades. However, evidence suggests that people do not save enough during peak earning years. Generation Xers (those born between 1965 and 1980 and currently middle aged) carry larger debt levels than other cohorts at similar stages—that is, at times when they should be paying down debt and saving for retirement.¹ Forecasts show that both baby boomers (those born between 1946 and 1964) and Generation Xers will likely have lower retirement incomes than those born in the 1930s and 1940s.²

Retirement Savings

While Social Security can provide a foundation of retirement income for many people, in order to have smooth consumption, the life cycle model assumes people save for retirement during their earning years. Many people think of saving as money deposited in a savings account, but saving is simply money not spent on current consumption or taxes. People can save by leaving money in a drawer, depositing in a savings account, or investing in stocks and bonds. It may be helpful to think of saving as giving up some current consumption in exchange for future consumption—in other words, saved money is set aside for future spending. This implies there is a trade-off—more saving requires less spending on current consumption. Saving allows people to have higher future consumption.

Americans are currently saving less than they have historically (see the graph below). Specifically, 38 million working-age households (45 percent) do not have enough assets set aside for retirement.³ And both those with high incomes and low incomes save very little. In fact, recent research finds that the primary determinant of wealth differences at retirement is not income but the choice to save or spend while young.⁴ Saving while young allows savers to take advantage of compound interest, which allows exponential growth of their money over time. And since more time means more growth, starting to save early makes a big difference.⁵

Workers can often save for retirement through their employer, typically through a defined benefit retirement plan (also known as a pension plan) and/or a defined contribution plan (such as a 401(k) plan). However, employees make more decisions with defined contribution plans, which requires more financial knowledge. When employees retire (unless they buy an annuity), they themselves decide how quickly to spend the money accumulated in the account. If they draw down the account too quickly, they risk outliving their retirement savings.

Types of Retirement Plans

For workers with a defined benefit retirement plan (a pension), employers promise a specific monthly retirement payment that is predetermined by a formula, often based on the employee’s income, years of service, and age at retirement. Because employees automatically participate in this type of plan and retirement payments are fixed, these programs set the retirement planning process on autopilot for many workers.

In a defined contribution plan (say a 401(k) plan), employees contribute money to their own retirement accounts and employers often match part of their contribution. The money in the account belongs to the future retiree. This type of plan requires employees to make more decisions, such as how much to save and which financial investments to use. The value of the holdings in a defined contribution plan will fluctuate based on the investment earnings.

There has been a rapid transition from defined benefit to defined contribution retirement plans. In 1980 about 40 percent of private-sector pension contributions flowed into defined contribution plans; by 2000 almost 90 percent flowed into these plans. (See Poterba, James M.; Venti, Steven F. and Wise, David A. “The Changing Landscape of Pensions in the United States,” in Annamaria Lusardi (ed.), Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs. Chap. 1. Chicago: University of Chicago Press, 2008, pp. 17-46.)

Because employees make these decisions for themselves, a higher degree of financial literacy is needed. Unfortunately, research consistently shows that a large portion of Americans are not financially literate and do not understand essential financial concepts such as how inflation and compound interest might affect their financial well-being. (See Lusardi, Annamaria; Mitchell, Olivia S. and Curto, Vilsa. “Financial Literacy among the Young.” Journal of Consumer Affairs Summer 2010, 44(2), pp. 358–80; Lusardi, Annamaria and Mitchell, Olivia S. “The Outlook for Financial Literacy,” in Olivia S. Mitchell and Annamaria Lusardi (eds.), Financial Literacy: Implications for Retirement Security and the Financial Marketplace. Chap. 1. New York: Oxford University Press, 2011, pp. 1-15.)

Conclusion

The life cycle model shows that saving for the future requires people to limit consumption during their working years and save so they will have a “nest egg” to draw on during retirement. Recent changes in how people save for retirement have shifted some responsibility from firms to individuals. Unfortunately, households are not saving enough for retirement. Two lessons emerge: Saving while young is important, and making the right savings and consumption decisions makes a difference. Financial literacy has always been important to achieve these financial goals, and its importance seems to be growing.