Wade Pfau, Ph.D., CFA

Lifecycle Finance: An Alternative For A Lifetime Financial Plan

Some of the most common rules of thumb used to guide retirement planning include the following:

  • Retirees should be able to sustainably withdraw 4% of their retirement date assets over their retirement.
  • Retirees should seek to replace 80% of their pre-retirement income after retiring.
  • Households should save 10% of their salary for retirement.

However, they are only rules of thumb, and they may be wildly off base for many reader situations. Economists, such as Boston University professor and fellow Forbes contributor Laurence Kotlikoff, have developed their own rigorous models related to lifetime financial planning in which variables like withdrawal rates and replacement rates serve no purpose.

For economists steeped in the tradition of lifecycle finance, the important variable is the lifetime standard of living which a household is able to support. People seek to smooth spending over their lifetimes in order to obtain the greatest satisfaction from their limited resources, and the problem to be solved is how high this standard of living can be. Because salary, household composition, taxes, mortgage payments, and so forth, vary so dramatically over a household’s lifecycle, trying to target basic rules of thumb related to replacement rates or withdrawal rates can end up causing more harm than good. Savings rates generally do not need to be fixed at some level, as it is consumption which should be fixed, and savings (or dissavings) is what remains after accounting for all income and expenses.

Though the models of lifecycle finance were developed as early as the 1920s, the framework can still sound foreign to those used to replacement rates and withdrawal rates, and so it is worth developing further how lifecycle economists think about the lifetime financial planning problem.

The objective of lifecycle finance is consumption smoothing. Households wish to spread their resources over their lifetime to maintain a consistent living standard. This means saving for retirement while one is working, or spending less than they earn so that they can later spend more than they earn after work stops. It also means using insurance to help smooth spending in face of the uncertainties related to health, disability, and death.

The living standard to be smoothed is on a per person basis. Families with young children can expect to spend more in total than empty nesters. And there are economies of scale, as living together helps to reduce total expenses relative to what one person would expect.

To figure out the sustainable living standard, it is necessary to try to plan out as best as possible the household’s trajectory on a year-by-year basis through a maximum planning age which is unlikely to be lived beyond. For this planning, monetary amounts should be treated in inflation-adjusted terms using today’s dollars. These calculations could be created with a spreadsheet or with software like Laurence Kotlikoff’s E$Planner, which have been designed for this purpose. Specialized software would be particularly helpful to make sure that taxes are calculated correctly.

For each year of life through the maximum planning age, it is important to track the number of people in the household, expected labor earnings, Social Security benefits, and other future income sources. Also important are fixed financial obligations which are paid outside of the calculation for the sustainable living standard, which include debt repayment, housing payments, special expenses like paying for a child’s college education, taxes, and insurance premiums. Assumptions about investment returns are also necessary to track the growth of financial assets and the asset income generated on an annual basis. It is important to make conservative assumptions about future earnings and investment returns. TIPS yields provide good guidance about investment returns.

The output of this process is the sustainable standard of living per adult through maximum age of life. The sustainable living standard is calculated in terms of spending after accounting for taxes, housing, insurance premiums, and loan payments.  It is the spending for everything else. From this output, we can then work back to figure out savings and withdrawals on a year-by-year basis. But these are determined after the fact, and not beforehand. Savings and withdrawals can fluctuate quite dramatically over time since these are the variables which adjust to maintain the sustainable living standard.

The power of this approach is that it provides a clear framework for evaluating different decisions in terms of the impacts on the sustainable lifetime standard of living. Matters which can be addressed include renting vs. buying a home, whether to have another child, whether to live in an expensive city, whether to contribute to tax-deferred retirement accounts, when to retire and to claim Social Security, and even whether it is financially advantageous to cohabitate or to get married. Comparing the sustainable living standard created with different decisions provides a clear way to compare the costs of different actions and to decide whether those costs are worth it.

Next, read Spending from Investment Portfolios.

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