Monday, July 19, 2010

Smooth Consumption over a Lifetime

For many people income levels over their lifetimes can be very uneven. Younger people tend to earn less per year than middle-aged workers, jobs are sometimes lost, and many women and some men take time off to raise children. There can also be windfalls such as inheritances or lottery winnings. Despite this unevenness in income, it is possible to smooth out yearly spending with appropriate saving and borrowing. However, is targeting smooth consumption a good idea?

I first encountered the idea of smooth consumption in Moshe Milevsky’s book Your Money Milestones. I’m not prepared to give a full review yet, but the idea of smooth consumption is worth some thought on its own.

Milevsky introduces the idea with an idealized example. Suppose you are 25 and know for certain that you’ll make $25,000 per year for 10 years, $100,000 per year for 20 years, and then $25,000 per year for 30 years and then die. If we ignore taxes, inflation, and interest, your total lifetime earnings will be $3 million or $50,000 per year over your remaining 60 years of life.

By borrowing in your early years, saving in your high-income years, and spending your savings later in life, you can smooth out your spending to exactly $50,000 per year. Milevsky says that “the correct way of thinking about savings rates is as the output of a financial plan that seeks to smooth consumption.”

However, things look different when we take into account interest on debt and returns on savings. Suppose that the income levels are actually in constant dollars (meaning that they increase with inflation). Suppose further that interest on debt and savings is 3% above inflation each year. How does this change the picture? Taking into account interest, it turns out that you can spend $55,000 each year and will run out of money after 60 years.

Now, what happens if you don’t start spending $55,000 per year right away? Suppose that you start spending $30,000 per year and increase this by $2500 per year until you reach some maximum and hold it steady for the rest of your life. In this case, the maximum yearly spending is $61,900 per year and your average yearly spending over the 60 years is $58,200 per year.

By delaying peak spending when you’re young you can increase the total amount you can spend over your lifetime. This illustrates the benefit of saving. This idea can be taken too far by scrimping all your life only to die while sitting on a mountain of money, but a reasonable amount of frugality while you are young can pay big dividends later in life.

Milevsky’s message of smoothing consumption is a very good idea for people who receive windfalls. Highly-paid athletes would be very smart to save heavily during their earning years. The situation is different when considering going into debt. The idea of smoothing consumption by spending heavily when you have a low income can be overdone. Borrowing for sensible things when you’re young like an education or a house can make sense, but spending twice your income while making $25,000 per year is crazy.

Sadly, good advice is often taken by the wrong people. Spendthrift young people may take Milevsky’s advice and overspend, and miserly people may take my approach and save every penny for a rainy day that never comes. On the whole, though, I think more young people need a message of saving than need a message to spend more.

9 comments:

  1. Milevsky's book is well worth reading for any serious investor and the concept of "smoothing consumption" is important to think about.
    I liked his chapter on taxes which I mentioned in my blog

    http://rwinvesting.blogspot.com/2010/06/taxesdiy-investor-milevsky.html

    His exercise of constructing a personal balance sheet by taking into account human capital is worth doing.

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  2. @DIY Investor: Including human capital on the personal balance sheet was interesting, but somewhat misleading. If you're going to include future income on a balance sheet due to the value of your human body and brain, you should probably include the future costs of your body's upkeep, such as food, shelter, and clothing. At least some minimal amount of money needed to live should count against human capital on a balance sheet.

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  3. Seems like you would need a crystal ball to know when to save and when to spend. I think it's hard for the younger population to predict when they will get higher paying jobs / careers, when they will be continuing their education and when they will be having children. Doesn't seem to be a good plan to be borrowing money for these things when nothing is set in stone.

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  4. @Jenna: That's another good reason to advise young people (or anyone else) not to borrow too heavily.

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  5. I'm with Jenna. This is just another form of speculation.

    No debt for me, thanks.

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  6. Besides the very good points made in your post and in the comments, there is a further risk of increasing spending above savings. Since it's far easier to add expenses than dial them back, I think consumption has a bias towards increasing over time.

    Planning for increasing income is fraught with risk. Using the prospects of increased income to justify today's purchases is silly, unless you have the powers of taxation and borrowing of a strong nation (probably still a bad idea). I think this strategy belongs in the realm of video games and cautionary novels.

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  7. @Patrick and @Gene: I was a little hesitant to disagree too strongly with Moshe Milevsky for fear of being proven wrong (he is a smart guy after all), but it seems that the commenters so far are prepared to be more critical that I was.

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  8. @Michael James: I imagine his justification for the strategy makes some sense. For instance, most of us cannot afford to purchase a home outright at the time we feel the need to enter the housing market.

    Also, by borrowing to get a degree which leads to a well-paying career, we may be using income smoothing wisely. Waiting to accumulate enough cash to do this might be the wrong move. Perhaps he doesn't advocate spending more to get the fancy HD television and premium satellite package in the name of income smoothing?

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  9. @Gene: I thought about that justification, but it doesn't fit well with his example. He has a 25-year old spending $50k per year and borrowing $25k per year to do it. The only way this can make sense is to count mortgage payments as consumption, which I usually don't.

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