Life Cycle Theories of Savings and Consumption
LIFE CYCLE THEORIES OF SAVINGS AND CONSUMPTION
Economists have developed three major theories of consumption and saving behavior: (1) The life-cycle hypothesis (Modigliani and Brumberg, 1954; Modigliani and Ando, 1957; Ando and Modigliani, 1963); (2) the permanent income hypothesis (Friedman, 1957); and (3) the relative income hypothesis (Dusenberry, 1949). All three theories have their conceptual roots in the microeconomic theory of consumer choice. However, the life-cycle and permanent income hypotheses are the most similar; both theories assume that individuals attempt to maximize their utility or personal well-being by balancing a lifetime stream of earnings with a lifetime pattern of consumption. The relative income hypothesis is quite different. Dusenberry theorized that individuals are less concerned with their absolute level of consumption than with their relative level—the idea of "keeping up with the Joneses."
The life-cycle hypothesis has been utilized extensively to examine savings and retirement behavior of older persons. This hypothesis begins with the observation that consumption needs and income are often unequal at various points in the life cycle. Younger people tend to have consumption needs that exceed their income. Their needs tend to be mainly for housing and education, and therefore they have little savings. In middle age, earnings generally rise, enabling debts accumulated earlier in life to be paid off and savings to be accumulated. Finally, in retirement, incomes decline and individuals consume out of previously accumulated savings.
Empirical studies of the life-cycle hypothesis have generated a large literature. Studies that have focused on the savings behavior of older persons, however, have been inconclusive regarding the correspondence between observed savings behavior and the pattern of saving and dissaving predicted by the life-cycle hypothesis. Many studies seemingly in conflict with the life-cycle hypothesis, have found that older persons continue to save in retirement. Several explanations have been offered for this. King (1985), for example, notes that saving in retirement is not necessarily inconsistent with the life-cycle hypothesis, if one accounts for the aversion of individuals to uncertainty about the future (e.g., how long they will live and future inflation). Another explanation is that the generosity of pensions reduces the need to save in preparation for retirement and to dissave while in retirement. Life-cycle savings patterns in some European countries that have generous pension systems such as France, Germany, and Italy appear to be consistent with this explanation. Another related explanation for lack of dissaving in retirement is that deteriorating health may limit the ability of individuals to consume at levels that are higher than their pension income. Moreover, the pension wealth that retired persons hold is not liquid and they are not able to draw down their pension wealth any faster than the annuity payments that they receive. This health aspect of life cycle savings and consumption patterns raises an interesting question: Should payments for health insurance also be viewed as a form of savings, and receipt of health care services as drawing down one's "health insurance wealth"?
A number of other studies, however, have found evidence of a hump-shaped pattern of savings that is consistent with the life-cycle hypothesis. It is important to note that most studies have tended to underestimate the degree of dissaving among older persons, because these studies have not generally accounted for the decumulation of pension wealth associated with Social Security and private pension payments.
Pension payments are probably the best example of decumulation of savings in the latter stages of the life cycle. Under Social Security and defined benefit pension plans, older persons have established a claim on a future stream of income payments that is generally some function of each person's earnings history and life expectancy. The expected total value of this stream of income payments in current dollars over their remaining lifetime is known as their pension wealth. Thus, as retirees receive pension payments, they draw down their pension wealth. This factor has generally not been taken into account in studies that have examined whether older persons dissave in retirement, as would be predicted by the life-cycle hypothesis. After accounting for personal contributions and withdrawal of benefits from pensions, Jappelli and Modigliani (1998) find evidence for the expected hump-shaped savings profile.
In an analysis of the savings behavior of the baby boom generation, Gist et al. (1999) estimate that Social Security and pension wealth accounted for more than half of all wealth for 90 percent of the pre-retired population. As a consequence, it seems clear that failing to account for the reduction in pension wealth implied by the receipt of Social Security or other defined benefit pension payments leads to a substantial underestimation of dissaving in retirement. Moreover, in countries such as the United States, where outof-pocket health care costs are rising more rapidly than the value of pension payments, one might expect to observe dissaving in the retirement years. In particular, among the old-old population, rising medical and long-term care expenditures are likely to occur at a point in the life cycle where, for many, the real value of their pension income has eroded over time and may be inadequate to cover out-of-pocket health care costs.
Implications for retirement behavior
The life-cycle hypothesis is closely related to the theory of work-leisure choice, which has been widely applied in the retirement literature. In the theory of work-leisure choice, individuals are assumed to maximize their utility derived from the consumption of goods and services, as well as from leisure. However, the consumption of goods and services requires income that, in turn, must be generated by earnings or savings. In this context, the retirement decision is based on the tradeoff between the utility gained from leisure time spent in retirement and the consumption of goods and services. Since retirement usually implies a substantial reduction of, or total absence of, wage income, the retirement decision is based on the point where an individual's savings accumulation has reached the level where it is sufficient to support the levels of consumption and leisure that maximizes his or her utility.
Implications for income adequacy
In considering the economic status of current and future older persons, few would argue that money income alone is the best measure. Another approach is to use household net worth as a measure of economic status. Net worth is defined as the total market value of all assets, such as home equity, stocks and bonds, and savings accounts, minus all debts, such as mortgages, school loans, and automobile loans. Net worth is a conceptually important measure because it reflects the ability to have met consumption needs in the past (net worth will be positive if income has been higher than expenditures up to that point in one's life), as well as the capacity to finance future consumption by drawing upon accumulated assets.
Michael Hurd (1990) provides an overview of the different ways in which researchers have used current income and net worth to measure economic status. A widely used approach is to convert net worth into an income stream (based on life expectancy and interest rate assumptions) and add this income stream to current income, excluding the income already being received from assets. Such studies consistently show that the income stream generated from assets is modest for most elderly persons, especially those who have low incomes to begin with. Consequently, annuitizing assets has limited promise as a mechanism for increasing the incomes of elderly persons with inadequate incomes.
If the life-cycle hypothesis is correct, one would expect older adults (at least at the beginning of retirement) to have higher wealth holdings than younger households. Consistent with this expectation, Edward Wolff (1998) found that mean household net worth was $173,700 for households of those under age sixty-five and $314,500 for households headed by those age sixty-five and older. Growing recognition of the greater wealth of older households relative to younger households has led to increased interest in the potential role of asset holdings for meeting public policy objectives. An important example of this interest is the concern that elderly households with low money incomes but large amounts of home equity may be receiving income transfers through government programs from younger households that have higher money incomes but who would not be as well-off as older households if one took account of wealth.
Studies have repeatedly found that, except for the most affluent of older households, the majority of net worth is held in the form of home equity. Eller (1994) found that, in 1991, the median net worth of older households was $88,192, but was only $26,442 with home equity excluded. Recent evidence indicates that the effects of annuitizing household wealth are fairly similar across age groups, and that such a policy would have almost no effect on reducing household income inequality.
Although converting assets into an income stream is appealing—because it enables current income and wealth to be combined into a single measure—there are some problems with using it to compare households in different age cohorts. First, there is the problem of choosing an appropriate interest or discount rate for valuing the income stream produced by an asset. The discount rate can greatly influence the size of the income stream generated by an asset. In addition to the choice of an appropriate discount rate, there is the problem of changes in the size of income streams produced by assets at different stages in the life cycle. For a given amount of wealth, income streams will be larger for those with shorter life expectancies, making older households appear to be more affluent than younger households with the same amount of income and wealth. In addition, comparisons between older and younger households based on the income value of their assets will be influenced by the generally higher stock of durable goods held by older households.
Implications for aggregate savings and consumption patterns
The life-cycle hypothesis suggests that population aging will initially lead to an increase in national savings as the proportion of the population in the maximum savings years increases. Cantor and Yuengart (1994) estimate that saving by the baby boom generation may add as much as 1.4 percent to the national savings rate between 1990 and 2010. As the population continues to age and the relative proportion of the population of those reaching retirement age grows relative to the middle-aged population, however, the life-cycle hypothesis predicts a reduction in aggregate savings.
The existence of public and private pension systems complicates the private savings patterns that would be predicted by the life-cycle hypothesis in the absence of these systems. In 1974, Martin Feldstein argued that the effect of Social Security on aggregate private savings is theoretically indeterminate. On the one hand, savings may decline because Social Security benefits reduce the need to save for retirement (the benefit, or asset substitution, effect). Conversely, the availability of Social Security benefits may encourage early retirement from the labor force. If so, a shorter working life and longer time spent in retirement would require increased savings rates (the induced retirement effect). As noted earlier, a substantial literature has attempted to identify which effect dominates, but this literature remains inconclusive.
The vast majority of the research on the life-cycle theory has focused on patterns of savings behavior. Savings, however, are only half of the story. To adequately interpret whether observed savings patterns are consistent with the life-cycle theory, it is also necessary to examine consumption patterns. And, as with savings, it is necessary to account not only for out-of-pocket consumption but also expenditures made on behalf of older persons in retirement (e.g., health care expenditures). As the population ages, the life-cycle consumption patterns of older persons—in particular, the greater allocation of expenditures to health care—will shift the composition of aggregate private household demand. In addition, public expenditures will shift in response to population aging (e.g., away from education expenditures for the young toward expenditures for pension payments and health care insurance). The economy has experienced the interaction of life-cycle consumption patterns and demographic change before, the baby boom generation swelled the demand for housing and education services in the 1950s and 1960s. Shifts in aggregate demand due to the aging of the baby boomers will be far less disruptive because, in contrast to the arrival of the baby boom generation, the economy and public policy will have many years to anticipate and adapt to population aging.
Collectively, these shifts in patterns of household and government spending will change the composition of aggregate demand in the economy. Population aging will also shift patterns of aggregate private savings, private pension wealth, and Social Security wealth. Given the prominence of the life-cycle hypothesis among economists, it is interesting that so little work has been conducted on life cycle consumption behavior of older persons. Debates about the out-of-pocket health care costs of older persons are a reflection of the intersection between economic resources, consumption needs, and public policy. The formulation of public policy for the elderly population needs to recognize this intersection and to be informed by careful research that explicitly accounts for the effects of life-cycle events on economic status in old age. The life-cycle hypothesis provides an integrated conceptual framework for the development of income maintenance and health care policy for older persons, and indicates clearly that income and health care policies should not be considered in isolation.
William H. Crown
See also Assets and Wealth; Consumption and Age; Economic Well-Being; Retirement, Decision Making; Savings.
Ando, A., and Modligliani, F. "The Life-Cycle Hypothesis of Saving: Aggregate Implications and Tests." American Economic Review 53 (1963): 55–84.
Bertaut, C., and Haliassos, M. "Precautionary Portfolio Behavior from a Life-Cycle Perspective." Journal of Economic Dynamics and Control 21 (1997): 1511–1542.
Borsch-Supan, A. "Saving and Consumption Patterns of the Elderly: the German Case." Journal of Population Economics 5 (1992): 289–303.
Borsch-Supan, A., and Stahl, K. "Life-Cycle Savings and Consumption Constraints." Journal of Population Economics 4 (1991): 233–255.
Crown, W. "Economic Status of the Elderly." In Handbook of Aging and the Social Sciences. Edited by R. H. Binstock and L. K George. New York: Academic Press, 2001. Pages 352–368.
Carroll, C., and Summers, L. "Consumption Growth Parallels Income Growth: Some New Evidence." In National Saving and Economic Performance. Edited by B. D. Bernheim and J. Shoven. Chicago: University of Chicago Press, 1991.
Cantor, R., and Yuengart, A. "The Baby Boom Generation and Aggregate Savings." Federal Reserve Bank of New York Quarterly Review (Summer/Fall 1994): 76–91.
Danziger, S.; van der Gaag, J.; Smolensky, E.; and Taussig, M. "The Life-Cycle Hypothesis and the Consumption Behavior of the Elderly." Journal of Post-Keynesian Economics 5 (1982): 208–227.
Eller, T. J. "Household Wealth and Asset Ownership, 1991." In Current Population Reports. 70–34. Washington, D.C.: U.S. Government Printing Office, 1994.
Feldstein, M. "Social Security, Induced Retirement, and Aggregate Capital Accumulation." Journal of Political Economy 82 (1974): 905–926.
Friedman, M. A Theory of the Consumption Function. Princeton, N.J.: Princeton University Press, 1957.
Fuchs, V. Provide, Provide: The Economics of Aging. NBER Working Paper 6642. Cambridge, Mass.: National Bureau of Economic Research, 1998.
Gist, J.; Wu, K.; and Ford, C. Do Baby Boomers Save and, If So, What For? Washington, D.C.: AARP, 1999.
Gokhale, J.; Kotlikoff, L.; and Sabelhaus, J. "Understanding the Postwar Decline in United States Saving: A Cohort Analysis." The Brookings Papers on Economic Activity.
Hurd, M. "Research on the Aged: Economic Status, Retirement and Consumption and Saving." Journal of Economic Literature 28 (1990): 565–637.
Juster, F. T. "Current and Prospective Financial Status of the Elderly Population." In Saving for Retirement. Edited by P. Cagan. Washington, D.C.: American Council of Life Insurance, 1981. Pages 24–66.
King, M. "The Economics of Saving: A Survey of Recent Contributions." In Frontiers of Economics. Edited by K. Arrow and S. Houkapohja. New York: Basil Blackwell, 1985. Pages 227–294.
Leonesio, M. "Economic Model of Work-Leisure Choice." In Handbook on Employment and the Elderly. Edited by W. Crown. Westport, Conn.: Greenwood Press, 1996. Pages 213–248.
McNeil, J., and Lamas, E. "Year-Apart Estimates of Household Net-Worth from the Survey of Income and Program Participation." In The Measurement of Saving, Investment, and Wealth. Edited by R. Lipsey and H. S. Tice. Chicago: University of Chicago Press, 1989. Pages 431–471.
Menchik, P., and David, M. "Income Distribution, Lifetime Savings, and Bequests." American Economic Review 73 (1983): 672–690.
Merrill, S. "Home Equity and the Elderly." In Retirement and Economic Behavior. Edited by H. Aaron and G. Burtless. Washington, D.C.: The Brookings Institution, 1994. Pages 197–227.
Mirer, T. "The Dissaving Behavior of the Retired Aged." Southern Economic Journal 46 (1980): 1197–1205.
Modigliani, F., and Ando, A. "Tests of the Life-Cycle Hypothesis of Savings." Bulletin of the Oxford University Institute of Economics and Statistics 19 (1957): 99–124.
Modigliani, F., and Brumberg, R. "Utility Analysis and the Consumption Function." In Post-Keynesian Economics. Edited by K. Kurihara. New Brunswick, N.J.: Rutgers University Press, 1954. Pages 338–436.
Radner, D. "The Wealth of the Aged and Nonaged, 1984." In The Measurement of Saving, Investment, and Wealth. Edited by R. Lipsey and H. Tice. Chicago, Ill.: The University of Chicago Press, 1989. Pages 645–689.
Torrey, B., and Tauber, C. "The Importance of Asset Income among the Elderly." Review of Income and Wealth 32 (1986): 443–449.
Venti, S., and Wise, D. Aging and the Income Value of Housing Wealth. NBER Working Paper no. 3547. Cambridge, Mass.: National Bureau of Economic Research, 1990.
Wolff, E. "Recent Trends in the Size Distribution of Household Wealth." Journal of Economic Perspectives 12, no. 3 (1998): 131–150.
More From encyclopedia.com
Savings , Savings Savings, from the perspective of the individual, comprises money set aside for future use. Savings, from the perspective of the economy, incl… Insurance Companies , ANNUITIES When planning for retirement, many Americans forget to plan for one of the most important risks—the risk of "living too long" and running o… Disposable Income , Discretionary income is a widely used but imprecise definition of that portion of personal income not spent on actual or perceived necessities. Thus… Bequest , Bequests EXPLAINING BEQUESTS BEQUESTS AND PUBLIC POLICY BIBLIOGRAPHY A bequest is the act of leaving personal wealth to a person or heir by a will. T… Income , Income Income is the money that individuals and businesses bring in during a given period as a result of work or investments. If, for example, a pers… Retirement , RETIREMENT PLANNING The vast majority of individuals and couples in the United States can look forward to their retirement—that period later in life…
About this article
Life Cycle Theories of Savings and Consumption
Updated About encyclopedia.com content Print Article
You Might Also Like
Life Cycle Theories of Savings and Consumption