Tuesday, March 4, 2014

Introduction to Lifecycle Finance

Lifecycle finance is how academics approach lifetime financial planning problems. The approach and emphasis can be quite different from a planning approach based on rules of thumb related to savings rates, income replacement rates, and withdrawal rates.

In my first column as a contributor to Forbes, I've attempted to provide a brief overview about the lifecycle finance approach to financial planning: "Lifecycle Finance: An Alternative for a Lifetime Financial Plan." The key variable is the sustainable standard of living over a household's lifetime, and I explain how savings rates, replacement rates, and withdrawal rates will only be determined after first figuring out the maximum sustainable standard of living one can enjoy with their lifetime resources. 

Then, turn your attention to MarketWatch, where I've provided a follow-up example about how this consumption smoothing problem is solved with lifecycle finance: "Lifecycle Finance: Upending the Old Retirement Rules."


  1. Hi Wade,
    Lifecycle finance is an important framework and my clients appreciate and understand the idea of consumption smoothing. Your readers should pick up a copy of Moshe Milevsky's book: Strategic Financial Planning over the Lifecycle: A Conceptual Approach to Personal Risk Management. It does contain some math, but those who don't appreciate the quant side of the book can still grasp the concepts which will result in better conversations with their clients.

    1. Jim,
      Thanks for the suggestion. I've got that one on my bookshelf and I still need to get it read.

  2. Hi Wade, consumption smoothing statically is attractive. But when you add sequence risk, dynamically it is difficult to apply because the future in unknowable. Your post http://wpfau.blogspot.com/2013/09/you-cant-control-when-youre-born.html is an example of how this gets complicated in practice. Your "Upending" article's closing sentence says it all "... different investment returns have very different implications for the appropriate financial plan. "

    This said, I am a firm believer that a person's/couple's Standard of Individual Living, what I call their SOIL, is a key reference point to plan with. During good income times, save more, and during poorer relative income times, save less. The standard of living itself is often not static, but stochastic.

    You've had many other blog postings suggesting that how much a person saves, or doesn't save, has a more direct impact of plan success than what they can't control directly like market sequence of returns. People can control their exposure to volatility, but the actual returns not so much.

    A good message though about focusing on standard of livingm and saving more than people tend to believe they need save.

    1. Thanks Larry.

      Lifecycle finance focuses more on asset-liability matching and includes an important role for a consumption floor. Sequence of returns risk can be avoided for essential needs by using what Modern Retirement Theory calls "secure, stable, and sustainable" assets. Then the idea would be that you have this secure floor in place before seeking upside. If you then get upside, you can raise your floor, but hopefully you don't have to lower it. I do know that you have concerns about whether income annuities are as secure as lifecycle finance will tend to assume.

  3. Very interesting article - thanks! Looking for some clarifications, though.

    "Because salary, household composition, taxes, mortgage payments, and so forth, vary so dramatically over a household's lifecycle, trying to target basic rules of thumb related to replacement rates, wealth accumulation targets, savings rates, or withdrawal rates, can end up causing more harm than good."

    Not that you are suggesting it, but wouldn't trying to come up with a Rule of Thumb for spending be equally risky? The variance on the spending numbers given when varying returns is not that far off from those for the Retirement Withdrawal Rate. Maybe the takeaway should be either avoid rules of thumb altogether, or only use them in the most conservative fashion.

    "For example, savings rates generally do not need to be fixed at some level, as it is the spending level which should be fixed. "

    Maybe I'm missing it, but in the simple model salary is fixed and you have a simple equation:
    salary - spending = savings

    Fixing spending or fixing savings has the same effect. Which direction come at it from should not matter, at least in this simple example. This simple example optimizes via: "Given all constraints, what is max I can spend". But isn't that equivalent to "Given all constraints, what is the least I must save"?

  4. Daniel,

    But there isn't a rule of thumb for spending. The amount you can spend is the result of doing all the calculations for the lifetime plan and is not guided by any sort of rules.

    You are right that as plans change, or as returns vary over time, resolving the plan each year will lead to a new spending level. Risk then is that events take place which reduce the lifetime standard of living. TIPS help remove downside on spending, but at the lost of potential upside. People have to decide about the tradeoff between downside and upside in the context of lifetime spending potential.

    About the salary equation, salary doesn't have to be the same each year. More generally, this is the living standard after removing fixed expenses like a mortgage and taxes. It's also based on household size, which can vary over time. So total spending each year will be different from what is determined to be the maximum per capital sustainable living standard.