Life Cycle Economics and the Safety First Strategy

Well-read retirees will no doubt recognize the terms “Safety First” and “sustainable withdrawal rates (SWR)”. “Safety First” refers to a retirement-spending strategy in which retirees first cover their essential retirement spending needs with assets that have no stock market risk and only then invest in a risky portfolio. SWR or “the probabilist school” as it is sometimes referred includes a strategy primarily based on stock market returns to fund both essential and non-essential retirement spending. The 4% Rule is a probabilist strategy.

The Safety First school is based on well-established Life-Cycle Economics theory that can be traced back to the early 1950s work of Franco Modigliani and his student, Richard Brumberg.  Zvi Bodie, Jonathan Treussard and Paul Willen wrote a discussion paper for the Boston Federal Reserve entitled, “The Theory of Life-Cycle Saving and Investing” that is far more accessible than the relevant economics literature.[1] Still, a lot of us checked out of ECON 101 the first time the professor said, “marginal propensity to consume” so I imagine there are many of us who could use a little extra help.

The authors identify three principles for applying the life-cycle theory to financial planning.

  1. Principle one tells us to focus not on the financial plan itself but “on the consumption profile that it implies.” Consumption equals income less savings during our working years and withdrawals from savings less health expenses in retirement.

  2. Principle two says to view our financial assets as vehicles for moving consumption from one location in the life cycle to another. We can move consumption from our high-earning years to retirement by saving.

  3. Principle three says a dollar is more valuable to an investor when consumption is low. A dollar of income is more valuable to us when we are unemployed, for example, than when we have a high-paying job.

Why should you care about life-cycle economics? It is a theoretical model of retirement finance and a decision-making framework that can serve as a guideline for answering our retirement finance questions. Life-cycle economics is based on Modigliani’s observation that people make consumption decisions based on both how much wealth they have today and how much they expect to have in the future. In other words, they desire a consistent standard of living across their entire lifetime.

When a young worker saves some of her earnings in a retirement plan, she is deciding that she may need some of the wealth she could otherwise spend immediately after she retires. Her behavior is consistent with life-cycle economics in that she is considering not only her current spending needs but also deferring some of that spending to her retirement years when she may need it more.

Life-cycle economics can provide guidelines for far more than retirement finance questions. We can use it to decide how much to save, whether to buy insurance or how to finance the purchase of a home. The answer to each question can be different depending on our current position in the life-cycle. It will provide a different answer to the question of how much to save, for example, for a household in early adulthood, middle age, and late working years.

Now we have the basis of life-cycle finance. It’s a set of guidelines, a “framework”, for making financial decisions based on our stage of the human life cycle, our current financial situation, our expectations of future financial condition and, most importantly, science. Life-cycle economics tells us that our goal should be to maximize our happiness (utility) of consumption (spending) over our lifetime. This is a far different goal than maximizing total portfolio returns as the SWR strategy recommends.

We allocate our current wealth such that our standard of living will be consistent throughout our lifetimes in good times and bad. This provides a framework for making retirement finance decisions. As Bodie, Treussard and Willen state in their discussion paper,”The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle.”

The following graph from Laurence Kotlikoff’s esplanner.com website explains this process. The red line is the household’s lifetime maximum sustainable living standard (consumption). The blue curve is lifetime earnings by age.

When earnings exceed the desired standard of living (the blue line is higher than the red), the household saves for future times when earnings may decline (blue line falls below the red). We smooth the peaks into the valleys until we find the highest “sustainable” amount we can spend (Kotlikoff’s MaxiFi product makes this complex decision for you.[2])

We allocate our current wealth such that our standard of living will be consistent throughout our lifetimes in good times and bad. This provides a framework for making retirement finance decisions. As Bodie, Treussard and Willen state in their discussion paper,”The theory teaches us to view financial assets as vehicles for transferring resources across different times and outcomes over the life cycle.”


ADDITIONAL READING

 


Originally posted at http://www.theretirementcafe.com/2020/06/life-cycle-economics-and-safety-first.html

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