Your Best Living Standard

An explanation

Last week, I dipped into the advisory world, curious about relatively new financial planning software on the market to be used by financial advisors and CFPs with their clients. Went on a Zoom call with an able young buck who guided me through the software from his spot in the northeast. Curious about how the software helps advisors make recommendations, I left wondering whether the software was a solid decision support system. It appeared to be a household organization and financial accounting tool that permits a planner to play what-if games for client questions through a manual trial-and-error process. No doubt the software is “in the cloud,” but mostly, I found it to be a modern-day pencil and paper with pretty graphics.

Then it occurred to me I have no right to be ivory tower hoity-toity about a successful enterprise with a financial planning fan base. I am taking a step back, putting on my boots, placing them in the stirrups, and bearing the responsibility for some plain speaking about why life-cycle theory offers a better approach to making household financial decisions. There are Nobel Prize winners underneath my saddle, and the academic community has been clunky in explaining how practice can be taken from theory.  Before you rush off to ChatGPT for an explanation of life-cycle theory, let me give it a go in a few words. Today, I am giving the same explanation live to my students.

Why Living Standard Matters

If I took a street poll and asked many people if they would like a higher standard of living than they have today, I’d expect 100% would say yes.   In economics, the living standard metric is linked to consumption or our spending.   We spend for basic food, shelter, and clothing, and we spend for fun.  How we spend for fun reflects our preferences in life. Preferences differentiate us from each other, and the amount of available fun we can consume varies based on our expected incomes and wealth. None of us has Elon’s or Rihanna’s available living standard, and most of us have a higher living standard than those in poverty. The working, lower-income household likely has a living standard restricted to just paying for life’s essentials. So, how does this all fit with financial decision-making?

Given your financial resources, any financial decision with multiple choices can have a living standard test: take the path with the highest living standard.  

Taking Practice from Theory

The living standard test is intuitively appealing. Most humans want a higher living standard. We can increase our living standards with a better job, more education, a generous family member, or luck. Each of us has a reasonable expectation of future prospects based on our stage in life. We are who we are with a set of skills, natural gifts, and fortitude to confront the risks of an uncertain future in employment, health, and investment performance.

During the early and mid-20th century, some economists’ work tracked toward explaining why households save money. It is an interesting question because savings have the cost of giving up spending today. If you force $2,000 into a savings account, then whatever you love for fun today is being deferred. Maybe even flat-out rejected forever. The observation people retire was some of the academic motivation. Many households will save some of their income when younger to fund expenses when older and not working.  Savings behavior during working years is a precaution for those with a prospective long life who are interested in retiring someday.

How a household best chooses a spending and investment pattern started with a more basic question: Why would a household stave off consumption while younger to live a decent life when older?

How Many Hotdogs Can You Eat?

The economics approach starts with how economists measure an individual’s happiness.  Economists call it “utility,” which, in our case, depends on the value an individual gets from consumption.   More consumption, more happiness.   

Suppose you are really hungry. It is time for a meal and you want a hotdog.  Consume a hotdog, you are happier, and your life is sustained.  Consume two at the same meal and you will be a little happier, but not as much utility from the second hotdog as the first.  Utility went up with the second hotdog, but not as much because you are becoming satiated. Hunger pangs had already receded. Economists coin a special phrase for this approach: individuals possess diminishing marginal utility.  More consumption is better overall, but on the margin, not too much of a contribution unless you are Joey Chestnut, world record-holder hotdog champion, who lives by a different happiness proposition, at least for hotdogs.

The reasoning extends over time.  A one-hotdog lunch with all the fixings is fantastic, particularly after a good workout!  But you need to eat tomorrow to live.  Rather than consume two hotdogs today, give up the extra satisfaction from a second hotdog and rotate it to another fantastic, life-sustaining meal tomorrow.   The extra utility give-up today is forsaken.   The economic explanation is the loss in utility today from the absence of the second hotdog is lower than the utility gained from having a hotdog to eat tomorrow.  If the alternative tomorrow is hunger, then tomorrow’s hotdog will have a lot of utility: tomorrow’s meal is life-sustaining. 

How does all this hotdog talk play for a vegan? A vegan is probably not on board. The vegan food analogy could be an 8 oz. portion of tofu added to Chinese stirfry. The same theory applies to vegans and everybody else in the world. While we have different preferences for what we consume, whether food or anything else, satiation still plays a role.

While diminishing marginal utility is important, a second influential economic element must be considered.  The ability to consume depends on household income, wealth, and other resources.  LeBron, Gaga, and Tiger are household names with more than most and, therefore, much higher prospective living standards.  Fewer hotdogs; more prime beef filet, lobster, and Beluga caviar.

By contrast, our graduating accounting students receive great job offers but are not yet world-renowned.  Offers pale compared to pro athletes and best-of-class artists, and the new grads’ living standards will be lower.  That is a straightforward observation that sets up the key question. If we combine utility theory with an individual’s income, wealth, longevity, and a satiation effect, what is the consumption result that produces the highest expected lifetime utility? Underneath the saddle is the horse in this race. For typical individuals under most conditions,

The best consumption level strives toward the smoothing level of consumption.

Whatever Your Life Stage: The Result is Generally Applicable

Whether a hotdog lover who expects to earn $75,000 a year with plans to retire at 75, a current retiree living off of social security retirement benefits, or a vegan making $200,000 a year who intends to live a long life and never retire, there is the best version of a financial plan that reveals the best consumption dollar amount today and for every future year. In other words, the plan that achieves the highest, sustainable living standard over a lifetime is the best financial plan.

What happens when things change? The living standard result for this year will surely change next year because financial lives change over short periods of time. New employment, unemployment, 401(k) actual performance, you name it, cause a needed re-evaluation. “We’re having a baby!” “We’re moving to Portugal!” The morning after an election. Any event that is economically consequential to your household.

Whether you use a planner, registered investment advisor, or PWM, the financial planning activity remains the same.   If I were an advisor, I’d have this on my letterhead: “Today, whatever the financial question, we will find our client’s highest, sustainable lifetime living standard.”