You’ve heard it all before… If you want to retire comfortably, you need to save a fixed percentage of your income year in and year out until the cows come home. This percentage varies with how soon you want to retire, what sort of standard of living you want to maintain in retirement, etc.
These sorts of solutions are attractive in their simplicity, but they tend to gloss over the fact that sometimes “life happens.” You get married, have kids, send them to college, etc. All the while, your budget is stretched thin and you get tired of living for tomorrow. Sound familiar? Well…
Instead of simply throwing up your hands and deciding that it’s impossible to save enough for a comfortable retirement, let me introduce you to an economic concept known as consumption smoothing.
What is consumption smoothing?
According to Wikipedia:
Consumption smoothing is an economic concept which refers to balancing out spending and saving to attain and maintain the highest possible living standard over the course of one’s life. This idea is notable because of its difference in approach to common knowledge about preparing for retirement, in which individuals are encouraged to save a particular % of their income throughout their life. Some believe that this approach is flawed, and typically leads to one of two outcomes: over-saving or over-spending.
The danger of over-saving is that you’ll wind up living like pauper early in life so you can live like royalty in retirement. The danger of over-spending is that you’ll have an artificially high standard of living when young only to be forced into delaying retirement and/or dramatically reducing your standard of living later in life.
With consumption smoothing, the goal is to even out the highs and lows such that you can maintain a relatively consistent standard of living over the course of your life.
The downside of consumption smoothing
There are, of course, some dangers associated with putting consumption smoothing into practice. First and foremost, as Scott Burns has noted, predicting how much you’ll need to save, spend, insure, etc. across the various stages of life is an incredibly complex undertaking.
According to Burns, you have to account for a host of factors including: household demographics, earnings, taxes, housing plans, economies of shared living, the costs of children, medical costs, retirement accounts, mortgages, special expenditures, pensions, Social Security benefits, and estate plans. While there are computer models available to crunch the numbers, such approaches are only as good as the assumptions on which they’re based, and small errors can compound into big differences down the line.
Another concern is that, given the complexity of this approach, you might end up throwing up our hands for another reason entirely. As Dartmouth economics professor Annamaria Lusardi has noted, “there is the drawback that the more complex it is, the more discouraging it is to use.” If you’re not prepared to spend the time and effort required to come up with the “right” solution, you’re probably better off with the old school approach.
Finally, it’s easy to use the consumption smoothing mindset as a convenient excuse to postpone saving until sometime way off in the future. Sure, you’ll be able to afford to save more once the kids are grown and out of the house, but you’ll have also given up years of compounding, meaning that you’ll have to save more to catch up. If you’re not careful, you might just wind up on the over-spending side of the equation.