MarketWatch
recently published a
somewhat controversial article that was picked up by a number of other news
organizations mainly because it ran counter to what nearly every financial
expert and teacher has preached for years (and thus made for great “click bait”
on the internet).
The
article, citing research based on Nobel-prize-winning economic theory dating
back to the 1950’s, advocates the Life Cycle Model of financial behavior. By the author’s own description, this model
is one “in which rational individuals allocate resources over their lifetimes
with the aim of avoiding sharp changes in their standard of living.”
To
illustrate, a young adult fresh out of college and in his first job is likely
on the low end of a high income scale at that point but has excellent prospects
for wage growth over the coming years.
According to this model, he should not be saving for retirement at that
point but instead use all of his income to establish and maintain a desirable
standard of living. As his income grows,
he can maintain that same standard of living but begin saving at some
point—probably middle age, when he has reached his peak earning years—for his
retirement. In theory, he should be
making enough in wages then to not only keep his accustomed lifestyle but have
enough left over to save adequately for retirement. Then, in his golden years that retirement
fund will pay for that same standard of living.
He will have smoothed out his consumption over all those years, never
living like a miser but never living extravagantly either.
“In
the life-cycle model, we are assuming you are getting the absolute most
happiness you can out of income each year,” explained Jason Scott, one of the
researchers. So the idea of socking
money away in an employer’s 401(k) plan and getting the employer match money
that goes with it is wrong, he believes, because the relatively low wage earner
in his early years would have to lower his standard of living in order to
save. That sacrifices happiness. It’s what Scott calls the “welfare cost”
of saving too early for retirement.
Where
can I even begin to tell all I think is wrong about the Life Cycle Model? Well, let’s start with the saying that “it is
not timing the market but time in the market” that matters. This simply means that instead of constantly
trying to time your investment purchases and sales to maximize your gains
(“buying low, selling high” and thus always glued to the market to guess when
it’s at its lowest or highest), investing early in life and leaving the money
there to grow over time through all those ups and downs is the most successful
way to save for the future, and study after study has demonstrated this. If an
individual waits until mid-life to start saving, he will be compelled to stash
away a much higher percentage of his income to achieve the level of savings
needed to sustain his established lifestyle in retirement.
And
not save when you are young? For
anything? How about an emergency fund
for a car repair you’ll likely need sooner or later? Or just a new set of tires? Or the $500 insurance deductible for that ER
visit? The study’s authors concede young
workers will need to save for emergencies, but how much is enough? One thousand dollars? Two?
Six months’ salary in case you get laid off? Yep, that can happen (just watch the job
market gyrate in the next recession).
Life happens. It is not always
the smooth ride, devoid of “sharp changes”, that is envisioned in some
financial theory, including this one.
How much welfare cost should that worker pay to save for those
things? The theory doesn’t answer that
question.
Saving
for retirement when you are young comes with some welfare costs, as Mr. Scott
argues, and he contends that those costs are not worth it, even for the
employer match to workers’ 401(k) accounts—the “free money” that an employee
gets for his retirement. Scott thinks
even that does not make it worth sacrificing a more comfortable standard of
living when you are in your twenties.
Spend away, save later. As he
went on to say, the puny gains to be had in the market, sometimes not even
keeping pace with inflation, are just not worth the pain of saving in the early
working years. Well sorry, Mr. Scott,
but the statistics consistently show that over time the market DOES reward
those who invest early and long.
I
believe he is comparing safer investments, like bank accounts, against
inflation, and by his own admission this is a weakness in his argument. But following the Life Cycle Model, an
individual who doesn’t start a retirement account until his late thirties or
early forties will not only have to invest larger sums (since the money will be
invested for a shorter time) but will likely have to put it in higher
return—and thus riskier—investments to make up for lost time; or else pony up
even larger sums of cash to set aside since it will grow very slowly in
standard bank accounts and certificates of deposit and not easily fund his
familiar lifestyle.
But
for me the most compelling argument against the Life Cycle Model is found in the
researchers’ own explanation of the model as one in which “rational individuals
allocate resources over their lifetime”.
Rational? That leaves out, oh,
99.44% of us when it comes to money. One
of the recurring themes in my blog is the irrationality of people when it comes
to money. We are products of our
upbringing; attitudes toward money—how to make it, spend it, save it, use it
for power, use it to help others—are shaped not by rational thinking but by
what we are taught or what we observe in others, especially our parents. Books and theses have been written about
this, and simple observation confirms it for me. For example, our natural tendency is to raise
our standard of living over time as our income increases in real value. How many people do you know that have as
their goal “smoothing out their standard of living” throughout their lives,
avoiding sharp changes in their money habits?
No, we want not only to improve our own financial lives over time but aim
for our children to do even better.
Once again,
academic economic theory falls flat in the face of human behavior.
Until next
time,
Roger
“The wise
man saves for the future, but the foolish man spends whatever he gets.”
Proverbs 21:20, The Living Bible
