Consumption Smoothing and You: Save While the Saving’s Good
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.
Published on July 9th, 2008 - 10 Comments
Filed under: Saving & Investing
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Scott Burns has a new book out called “Spend ‘Till the End” which is all about consumption smoothing and challenges the conventional wisdom when it comes to things like when to take Social Security, paying off your mortgage, etc. Scott also has an excellent website called Assetbuilder where he posts thought-provoking articles like this:
http://assetbuilder.com/blogs/.....nning.aspx
All consumption smoothing does is take your entire lifestyle into account as part of your financial future along with non-financial things you can do to ease the financial ups and downs of living. Good stuff all the way around!
Comment by Eric — Jul 9th 2008 @ 12:08 pmGreat post - this is definitely something I aspire to particularly with regards to retirement. Problem is that it is so hard to do.
Mike
Comment by Four Pillars — Jul 9th 2008 @ 1:19 pmThis is an intriguing idea, something I’m definitely going to look into. After many years of saving since my Lovely Wife and I got out of college, I’m tired of seeming to put off some good life while putting a bunch of funds for retirement. I’m certainly not wanting to shortchange my retirement and future but there has to be a balance — I’m not sure I’ve found it. Also compounding our situation is Lovely Wife is now stay-at-home which halve our income. Lots of financial flux on our household.
Comment by The Other Eric — Jul 9th 2008 @ 1:35 pmIt is such a tough feeling. Today I wrote about almost living large. That is exactly it. I want to live large but to get there will take time and what exactly living large is defined by the standards you set yourself.
There is no easy choice about how much to spend. Only you can decide.
Comment by livingalmostlarge — Jul 9th 2008 @ 5:57 pmI wrote a similar article on consumption smoothing last week. It’s not only those that set a predetermined percentage of their salary away that can benefit from the concept of consumption smoothing.
There seem to be some families (especially among the personal finance blogging world) that live frugally all their lives to stockpile as much cash as they possibly can for retirement. Then they get to retirement with millions of dollars and don’t know what to do with it all.
It’s all about finding a balance between what you Want to have today, and what you NEED to have tomorrow!
Comment by Benjamin — Jul 10th 2008 @ 12:25 amFor me, the most effective way to save money for retirement is to do it automatically. That is, do it once then forget it! Setting apart a % of your income every paycheck requires a lot of discipline and for most people not achievable at all. By doing it automatically, you save yourself the effort of having to spend time dividing money for retirement and for yourself. How do you do it automatically?
Ask your company finance guy if your company’s preferred bank can automatically deduct a certain % from your salary automatically and store it in your retirement fund or savings fund.
Remember, you don’t spend what you can see
Comment by Sam — Jul 10th 2008 @ 1:18 amSam said:
Remember, you don’t spend what you can see
Um, are you sure about that?
Comment by Andy — Jul 17th 2008 @ 10:48 amMy bad….should have been “you don’t spend what you CAN’T see”. This is the main concept from this book I’ve just finished Automatic Millionaire by David Bach.
Cheers!
Comment by Sam — Jul 17th 2008 @ 11:24 amSam
Great post. It’s a great reminder of the importance of balance. No one knows how long he has on this planet, so you can’t live exclusively for a tomorrow that may never come. Consumption smoothing is a fascinating concept made a lot easier to execute if you are able to and choose to save aggressively when you are young.
Comment by Michael — Jul 21st 2008 @ 9:23 amThere’s a song here:
EarningTime, and the savin’ is easy…
Comment by Andy — Jul 22nd 2008 @ 4:56 pm