The concept of lifecycle savings and investing has been around since the 1950’s, and has been refined and distilled by economists throughout the years. The Life Cycle Hypothesis (LCH) assumes that people alter their savings and consumption habits to maintain a relatively stable lifestyle within the concept of a lifetime budget constraint.
Spending and savings tend to be calibrated to save enough to maintain a particular lifestyle at retirement – not to sacrifice unduly during your working life to have excess money at retirement, or spend recklessly today with no thoughts of your retirement.
If you are interested in relative stability, using the life-cycle approach allows you to look at all of your economic decisions through a framework that you construct yourself based on what is important to you. Your savings model takes into account not only the time value of money, but outcomes and their relative level of importance to you.
For example, the decision to rent a house or buy one is in most respects a financial decision based on the expected costs of renting. This depends on assumptions of future mortgage interest rates vs. future rent payments, but with the life-cycle approach it also considers your consumption needs and the importance and utility of home ownership to the family.
Do you prefer that your consumption not be tied up in a less liquid asset such as a house? Is your family mobile at the point where the burden of house payments could be a detriment, compared to a future date where home equity and establishing roots may be more desirable? You are assessing potential outcomes and the effect of moving various types of consumption to different points in your life cycle, or avoiding them altogether.
Most people are familiar with the lifecycle concept in investing as it applies to balancing an investment portfolio with respect to risk. In virtually all cases, lifecycle funds shift toward higher levels of conservative investments such as bonds and cash as you age. The difference is in how long they hold a higher ratio of riskier stocks and how swiftly they change over to conservative investments.
Lifecycle funds tend to fall into two basic categories:
- Ratio-Based Funds – These funds change the ratio of stocks to bonds/cash in some proportion and rate based on your current age. Simple straight-line formulas subtract your age from 100 or 110 to derive the amount you invest in equities; others break the formula up into separate straight-line segments or curves that vary in aggressiveness depending on your current age and how far behind you may be in reaching your retirement goals.
- Target Date Funds –These funds assume a specific retirement date and a specific ratio of stocks versus bonds/cash to be achieved at that date. Again, different plans offer different levels of aggressiveness before that date to meet your goals, but they intersect at that target retirement point. Plans may be “to” plans that maintain the ratio from your target date on, or “through” plans that keep more in equities at the target date and reach the most conservative ratio later in retirement.
These appeal to many investors because they are generally hands-off, self-propelling funds. If you enjoy trading or think you can do better than the market, these funds are not for you, but average investors with limited acumen or little interest in rebalancing their own portfolios find them appealing.
There are many books and online resources to study lifecycle saving and investing in greater detail – but to generalize, these savings and investment approaches are going to appeal to those with a broader view and those who enjoy planning ahead and evaluating risk versus reward in their investments and purchases. If you fall into this category, we suggest researching the topic further to see if it fits your lifestyle and interests.
MoneyTips features a series of articles on lifecycle planning starting with Lifecycle Planning in your Twenties.