As the baby boomers move inexorably closer to retirement, many have lamented the plight of the generation, which appears to have dramatically undersaved and therefore is ill prepared for retirement. Yet the reality is that given how spending fluctuates through the working years – especially when raising a family – it may be entirely normal for couples to save less during the bulk of their working years, and instead save substantially in just the final years before retirement when the cost of raising children winds down. In turn, savings in the early years can actually be less effective than reinvesting into the individual’s "human capital" and increasing lifetime earnings. And in such an environment, the real issue is not effectively saving in the early years, but instead is to proactively manage spending to ensure it does not ramp up too rapidly in the later years. Combined together, this suggests that the reality may be that back-loading retirement savings into the final years before retirement doesn’t mean baby boomers are "behind" but instead that they have been following a remarkably normal and even "optimal" path!
The inspiration for this week’s blog post is a continuation of last week’s discussion about how just saving a percentage of income each year may be ineffective advice, because in reality with a real increase in income and a stable spending level, the savings rate should rise significantly in later years. Yet retirement saving shouldn’t rise in later years just because income increases faster than spending; couples who raise families may also find that retirement savings is constrained in early years due to the impact of paying for children and saving for college. As a result, the reality is that for clients with rising incomes and raising families, it may be entirely normal for the bulk of retirement savings to occur in a relatively limited number of years right before retirement – which in point of fact, is the exact plight of most baby boomers today!
Traditional Planning For Saving And Spending
In the traditional accumulation planning approach, clients and planners focus on income, and then allocate the income to various categories, including saving and spending. The challenge, however, is that as personal circumstances change over time – e.g., as children are born, age, and leave the house, income goes through fluctuations, needs change, etc. – trying to maintain a stable saving pattern in the face of fluctuating needs leads to volatile spending patterns.
For instance, if the couple earns $100,000/year and seeks to save 20% (or $20,000) of income, and owes another 20% for taxes, the couple only has $60,000/year (or $5,000/month) remaining for personal consumption. If a child is born that requires additional ongoing expenses, not to mention additional college savings, the family is forced to reduce their $60,000/year spending to adjust, constraining their lifestyle.
Spending And Saving – Ideal Versus Reality
Of course, in reality the adjustment where the family curtails its other spending to accommodate new children or household expenses while maintaining savings rarely happens. Instead, expenses ramp up with the addition of a child to the family, and in turn the family’s total spending rises, carving away a portion of the amounts previously being saved.
The end result – expenses rise, savings decline, and the family struggles to find enough money at the end of the month to support their savings goals. Then at some point in the future, when the children eventually leave the home (and/or finally graduate from college), family expenses decline as the couple reverts to their prior 2-person household, allowing for greater room for savings. If income has grown by a real rate of return above inflation, savings in the later years may ramp up even further.
In other words, the ideal where clients save steadily every year simply may not be realistic planning.
Smooth Savings Versus A Focus On Consumption
What the above example illustrates is that while financial planning often advocates a smooth and steady savings path – and let spending adjust as it must – in reality most people have uneven spending and let the savings adjust as it must.
However, this doesn’t necessarily have to be problematic. After all, if the reality is that spending is uneven as people raise families, and furthermore that it’s more productive to invest in one’s career in the early years to reap the real income increases down the road, then in fact most people should end out consuming the majority of their income for the first half of their working years… until they finally reach that combination of peak earnings years and the decline in spending that accompanies children leaving the house, allowing for a transition to significant saving in the home stretch to retirement.
Notably, then, the key to making the consumption-centric approach work is to keep spending at reasonable levels throughout the time horizon – especially when other family/children/education expenses decline in the later years. If "temporarily" higher spending on family, children, and education is replaced by savings, it becomes remarkably easy to catch up; if the spending simply shifts to other spending, though, the savings rate never rises enough and the couple ends out behind on retirement.
Financial Planning Implications
If we assume that in fact an uneven lifetime spending pattern is the normal reality for most people – which makes a level spending approach impractical or outright impossible – then many traditional financial planning implications shift.
For instance, the reality may be that baby boomers that have little saved for retirement are in fact not behind, but merely right on track, positioned to capitalize on their empty nests and peak earnings years to save substantial sums of money to close the retirement savings gap.
In turn, this implies that the focal point for advice through most of the working years should not be on saving and investing at all, but instead on further growing future earnings (which may actually involve not saving in retirement accounts but instead investing in human capital), and on maintaining a steady lifestyle so that excess income can be allocated to savings as received. In this framework, the reality is that baby boomers that are behind may not be in trouble because they failed to save in their early years, but instead simply because they allowed their spending to ramp up too much in the later years.
But the bottom line is that the traditional approach – advocating a steady savings rate every year from the beginning of the working years to the end – may be both unrealistic given the unsteady nature of consumption throughout life, unnecessary for those whose income grows in excess of inflation over time, and suboptimal for those who could more effectively reinvest early savings into growing their human capital instead of their financial capital.
So what do you think? Have we been too focused on saving in the early working years? Is the reality that baby boomers have simply been following the normal progression, where savings is loaded into the later years when family expenses decline and earnings peak? Does the focus need to shift from steady savings to a steadier path of spending?
(This article was featured in the Carnival of Personal Finance #378 hosted on NerdWallet.)