Subscribers will read my posts on Personal Finance Economics and find them short, sweet, and to the point. Written with educational intent, I try to begin with a tasty broth but at the pace of Aaron Rodgers running a two-minute drill. Let’s get warmed up with some soup.
The Financial Planning Broth
Walking on the beach life is good for Sergio and Jesse. With two incomes and many discretionary spending interests, what would they experience if they reached out for some financial planning? More likely than not, they would be taken through a reasonably standardized, sequential process explained by a planner,
We will analyze your current financial position
We will establish a budget and short-term and long-term goals for saving and investing
We will identify strategies to reach these goals
We will help you implement the plan
We will evaluate the plan yearly and as life changes (you move, you get married, you have a child, you divorce, you retire, your spouse dies)
A conventional approach is short on specifics that can be tailored to the household. The listing leads to questions. Analysis? What is a budget? Strategies, goals, evaluation. Words that need seasoning.
The conventional approach can be applied to every household, but there is no reason to think any home is ready for saving and investing. I agree the first step is to benchmark the current financial position. Whatever the planning methodology, that is a must. Over time, life-cycle economics offers the best approach to turning broth into soup. It adds protein, carbs, salt, and pepper. It is so valuable it would be my comparative advantage if I were a practitioner selling financial planning services. If I am a DIYer and want to shore up my financial future, knowing as a paid subscriber, I can come here and have an exchange about my concerns should be comforting.
The structure built by life-cycle economics is how best an individual or household should allocate their financial resources across the expected lifetime span. What is your max year of life? Is it greater than the average American's? I am betting it is because family history, lifestyle, and current health are not considered in the numbers reported by the Social Security Administration. The max year is a click higher than the expected lifetime. Even then, prescriptive savings for everybody cannot be the answer.
Our households are different. Yours. Mine. The neighbors. Jill, the admin. Moreover, adults within a single family are different. Aaron Stevens and I begin to take this on directly in the introduction to our book.
“A statement such as people should save for a healthy financial future is not very interesting. More interesting is why do people save?”
That was the question asked by Modigliani and Brumberg, and if a Nobel prize winner put thought to this question, should it not be essential for us to think about it, too? We observe today three motivators for savings,
Retirement, when a household needs to live when it no longer has an income.
An emergency fund when households worry about either income disruptions, surprise expenses, or both.
Targeting a major purchase goal such as a home, car, and child’s education.
The Cost of Savings
The implication of economic research into savings is not that it is required. Rather, it is to understand why people save in some circumstances and not in others. Because so much conventional advisor advice has been focused on investment sales, savings are necessary to sell a product. But, to identify savings as a must is to ignore its cost. At an extreme, a 30-year-old couple with after-tax take-home pay of $100,000 could save $100,000 for retirement, but do you think you would know any twosome who does that? How would they live? Let’s move toward more realism. Saving $80,000 today would permit $20,000 of today’s expenses for food, shelter, and clothing to be covered, but could the household live on $20,000 today? Probably not. Is saving $40,000 better? How about saving just $10,000? No savings? How about negative savings? Negative savings recognize that income is too low to handle household expenses, and bills are paid by selling financial assets or borrowing via credit cards. That is not necessarily irrational behavior.
What is the magic amount of savings for a household? It depends on all the household's attributes: preferences, expected income, longevity, the prospect of an inheritance, the desire to work, the tax code, the structure of social security benefits, etc. Once all the attributes are considered (yes, the list is finite), sophisticated computing is required to arrive at the answer.
I want to convince you by logic that there can be no savings rule of thumb. It has to meet a well-defined objective. If you retire at 70, plan on living well beyond that age, and leave an inheritance, we can now compute the savings required to meet that objective while preserving your lifestyle over the long run. No back-of-the-envelope or rule-of-thumb approach will work. If you want to save for a new EV in three years when battery technology advances, you can set aside funds today to meet that objective. Suppose you are single and uninterested in endowing another. You don’t want to set aside money for a significant purchase or don’t plan on retiring. In that case, the savings required under sophisticated economics-based financial planning will likely be minimal.
The Beauty of the Life-Cycle Model
The beauty of the life-cycle model is that it provides a path for practical problems. Is it used in practice? Yes. Does the life-cycle model give us a really good way to think about spending this year, next year, and many years into the future? It does.
Let’s go back to our 30-year-old couple with $100,000 of income. That is just this year. If our couple is like most people, there will be an income path up to retirement, full of all life’s uncertainties. You and I know that their standard of living will not be like Musk or Gates and not quite to the level of their neighbors with a $350,000 annual after-tax income. Yet, in both cases, as all the essential financial information is assembled, the life-cycle model will help either couple determine their spending, that is, their sustainable level of spending over their lifetime. Approximating this living standard is the required first step of household finance. Knowing your ideal living standard brings economic thinking to financial planning. It gives the soup its richness.