Monday, October 14, 2013

Your Own Personal Fiscal Cliff

Each of us faces a personal "fiscal cliff" when we retire. The challenge of avoiding that cliff can perhaps best be shown with a graph of typical lifetime income.

The green columns represent your lifetime earnings and the red columns your lifetime expenses. The problem, of course, is that earnings stop when you retire, but expenses don't. That's only a problem if you live long enough to retire, but it becomes a really big problem if you live to age 95 or 100.

See the earnings after age 65? That's a fiscal cliff.

This may surprise you if you are 25 (I didn't give it a lot of thought back then), but if you live long enough, one day you will no longer be able to work for a living but you will still need to eat.

Economists tell us that we can "smooth consumption" by saving when we have lots of income and borrowing when we have less.  The principal assumption behind consumption smoothing is that people don't want to live royally while they are working if it will mean living as a pauper after they retire. Nor do they want a lavish retirement if it means scrimping for the forty years prior. Instead, the assumption is that people would prefer similar standards of living before and after retiring.

The approach has its limits. No one (except your parents, perhaps) will loan you much money when you are 25 because you expect to earn a lot when you are 55. Also, when you're 25, you haven't saved a lot of money so you can't borrow much from your own savings.

Nonetheless, it seems reasonable that we can smooth our lifetime income to some extent at certain times of our life when we are not "borrowing-constrained".

A good time to smooth our consumption (spending) would be between our working years and our retirement years. Rather than spend all of our money while we are earning it, we could delay some of that consumption until after we retire.

We could save money while we are working so we can spend it after we retire and that reduces our standard of living before we retire. We could also just spend less after we retire, reducing our standard of living when we are older. The idea behind consumption smoothing is that you minimize the differences so you have a decent standard of living before you retire and a similar one after.

If you save too much while you work, you unnecessarily reduce your standard of living before you retire. Save too little, and you see a big decline in your standard of living after you retire.

Even saving enough is an incredible challenge, so I wouldn't worry a lot about saving too much. In retirement planning, the first goal is to avoid the worst case scenarios and that would be saving too little and running out of money before you die. Unfortunately, as I have explained in prior posts, it is nearly impossible to know how much "enough" is.

The challenge, then, is to balance your standard of living before and after retirement while having no good way to predict either. Here's a "save too much" chart, a "save too little" chart", and an "ideal savings" chart.
None of the figures behind these charts is even a little predictable (your lifetime earnings, your lifetime expenses, how long you will live, etc.), but we can use them to see the principles we should establish for paying for our retirement years. Like a lot of things in the field of economics, the models are better at explaining how things work in general than they are at predicting outcomes with any precision.

The idea is that we can lower the red line on the left side of the chart by saving and then spend those savings after we retire, which raises the red line on the right. The closer we bring those two parts of the red line toward the green line in between, the more our standard of living in retirement is like the one we had while we were working.

(It works in reverse for the blue line, which represents the unlikely "oversaving" scenario.)

There is an excellent paper on the subject entitled The Theory of Life-Cycle Saving and Investing by Zvi Bodie if you're interested in a more rigorous explanation. There is also an excellent website and software product ($ESPlanner) created by Professor Laurence Kotlikoff if you'd like to play around with consumption smoothing.

So, in a nutshell, the Standard of Living v. Savings chart above explains retirement planning: finding the maximum standard of living line before retirement that you can sustain after retirement. In other words, to save the amount that moves your consumption close to the green line.

Next, in Moving the Red Line, we'll talk about how to move those lines.

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