The Common Sense of Consumption Smoothing
“Consumption Smoothing” is a coinage only an economist could love. But like it or not, it's something we all do on a routine basis in our short-term economic lives. If we get paid once a month, we try to budget to spend the same amount each week. I.e, we try to maintain a stable living standard per household member.
Surprisingly, we rarely apply this same common sense approach to our long-term economic lives. If we have assets, labor earnings, asset income, future Social Security and pension benefits, retirement account withdrawals, mortgage payments, and other planned expenses, why don’t we smooth our living standards across years, not just weeks and months. And why not smooth it across all present and future assets and income and all those changes in “off-the-top” expenses so that discretionary spending per household remains constant each year over the rest of our lives?
We don’t do this because it’s far beyond our brains’ computational capacities, and, until very recently, there were no publicly available computer tools that could perform such analyses inside a month. Furthermore, the financial planning industry has done its best to violate economic common sense by telling us to put our saving on autopilot and let out living standard go to hell, if need be, in order to meet their exaggerated estimates of our future spending needs. This approach gives them a steady and growing stream of assets to manage, for which they typically charge high fees, but it means starving today to splurge at 80.
Consumption-smoothing is complex, not just because of the many factors involved, but also because one needs to think carefully about future taxes and changing household demographics (kids of different ages heading out of the house at different points in time). Long-term consumption smoothing also requires dealing with borrowing constraints—the fact that we generally neither want to nor can take on debt to have a smooth living standard ride.
Today, there is no need to listen to financial planners who want to pad their pockets while making your economic life tougher than it already is. ESPlannerBASIC—our company’s free consumption-smoothing tool—can quickly solve your consumption-smoothing problem. And if you’d like to see just how nuts conventional planning can be, you can choose to set your post-retirement discretionary spending target using the financial planning community’s standard rule of dumb—target to spend in retirement 75 to 85 percent of your pre-retirement earnings.
We gave this conventional approach a try with Jack and Janet, a hypothetical couple living in Maine.
- Age: 35
- Children: One born in 2004 and one born in 2009.
- Earnings: 100K each
- 401(k): 3K individual + 3K company match
- Mortgage: 150K (943 per month) 2000 in property taxes and 1000 in hazard insurance.
- College costs: $20K per year when the adults are age 48-51 and again 54-57.
- Each child adds to household spending by a factor of 70% of an adult before leaving home.
With a combined income of $200K, conventional planning advice would have this couple set a target of $160K of retirement spending, which is 80% of their pre-retirement income. Consider what their economic lives would look like in order to make this happen.
As you can see above, their discretionary spending—the amount left over to spend each year after off-the-top expenses—would need to be negative through age 64 in order to provide discretionary spending from age 65-100 (we show the first three years) that is 80% of their pre-retirement income. In other words, such a plan is nuts.
If we dial back to $140K, a target of 70%, the family can now live on $8,304 annually (or its per-adult household equivalent, providing proportionately more before children move away) until retirement at which point they’ll have their $140K in discretionary spending.
However, this $8,304 is not affordable either, for even though housing, taxes, property tax and home insurance are paid off the top, the annual $8,304 that remains is just 8.5% of their retirement spending and surely not what a couple with $200K in annual income has in mind.
If we set a target of 50% or $100K of retirement spending as seen in the chart below, the couple can now have discretionary spending of $46,995 (or its higher household equivalent when children are at home) prior to retirement in order to afford the $100K during retirement. Although this plan could conceivably work, they will see their spending more than double at age 65 indicating that for 30 pre-retirement years they will have needlessly sacrificed much more than was needed as we see below.
As we see next, a target of 90K (45% of their $200K) will allow them to spend $56,262 or the household equivalent with children in the home. We are gradually raising pre-retirement living standard and thus lowering retirement living standard in order to make the two “smooth” or equivalent, yet all this guesswork is revealing the shortcomings of the method.
Keep in mind, ESPlanner is adjusting spending for several key economic expenses: housing, taxes, life insurance, children in the home and college costs. In those staggered years when college tuition is due, ESPlanner is smoothing the family’s living standard using annual saving and dissaving. In other words, it is proportionally adjusting discretionary spending to supply more money when needed (represented by the blue bars) so that the equivalent per-adult living standard (represented by the red line) remains as smooth as is economically possible.
Were ESPlanner not smoothing consumption, the family would have to lower their living standard with children at home, raise it when they leave, lower it again with the first child in college, raise it for two years, then lower it again with the second child in college, then raise it abruptly to match the retirement spending target. This living standard disruption is, unfortunately, commonplace in conventional planning. It would, in fact, be more severe than what the red living-standard lines in these charts indicate because ESPlanner is smoothing the living standard despite the constraint of the retirement target percentages.
So finally, we reset the planning approach in ESPlanner-BASIC and let the program do the calculation that our guesswork has failed to deliver. And as we now see below, the living standard line is smooth.
Discretionary spending still adjusts for when the first and second child leave the home (which is why the blue bars drop lower at those years)—and like the other profiles, spending through college is adjusted so that living standard does not drop with these special expenditures. But what’s most important to observe in the chart above is that living standard is never disrupted. The retirement living standard at age 65 is the same as their living standard at age 35 and discretionary spending is adjusted to reflect our economic assumption that two adults live together as cheaply as 1.6.
We did not need to do all of this guesswork except to make our point that a smooth living standard—the end goal of retirement planning—is not something that’s easy to calculate without the proper tool. Had we guessed a target of $72,343 of discretionary spending in retirement we’d have hit a bull’s eye. But this number, which happens to be 36.2% of the $200K household income, is not intuitive nor the result of any rule of thumb. We finally have discovered the solution to a very complicated mathematical calculation that took ESPlanner just 2 seconds to calculate