Consumption Smoothing – Spend ’til the End

I have read (and continue to read) many books on retirement planning. Most of them have been on the money and financial aspects of retirement. Lately, I have taken more interest in the mental and emotional parts of retirement. I am reading a book now that addresses those specific issues. I will be reviewing that book here soon.

So far, my favorite book on financial planning for retirement is Spend ’til the End by Laurence Kotlikoff and Scott Burns. This book focuses on the application of consumption smoothing to a lifetime of spending, saving, and investing, all leading to retirement.

What is Consumption Smoothing?

Consumption smoothing is not a fad, a “get rich quick” scheme, or “get out of debt” program you see advertised on radio and TV.  It is, rather, a life cycle saving theory and concept that is now well-established in the science of economics.  

Many economists give credit to MIT economist late Franco Modigliani for originating “consumption smoothing” for which he won a Nobel prize in 1985.  

Without going into a lot of detail here, consumption smoothing proposes that, beginning with early adulthood, we try to “smooth” our consumption over our entire lifetimes so as to maximize the useful value of money that is available to us.  This means that we don’t excessively deprive ourselves when we are young to benefit old age. Neither do we waste money when we are young to the point that we are poor in our old age. If we design our spending, saving, and investing plans properly using the consumption smoothing concept, we do not experience a sudden change in lifestyle when we retire.

Here is a graph that simplistically represents the goal of consumption smoothing.

(Source:  Kotlikoff and Burns)  Note that that the orange line represents the target of consumption smoothing:  the “highest sustainable living standard” over a lifetime of earnings.

Spend ’til the End

Conventional personal financial planners do not typically use consumption smoothing theory when advising baby boomers and other clients preparing for retirement.  There are two reasons for this. First, most are not trained in this area of economics. Second, the practical application of the consumption smoothing concept requires simultaneous consideration of numerous factors, including income, local, state, and federal taxes, family size, housing costs, college costs, pension income, Social Security, insurance, and retirement withdrawal rates. There just haven’t been any tools available to do this. Instead, most financial planners focus on solving one or more financial problems in relative isolation.  ”Targeted spending” is frequently the result of conventional financial planning. But targeted spending often results in lifestyle disruptions.

This is where I find that the Spend ’til the End Book can be extremely helpful so baby boomers. First, it explains the consumption smoothing concept in understandable terms. Second, it supports its practical application with real data. Third, it provides concrete guidance in how you can use consumption smoothing to optimize your own spending, saving, and investing strategies so as to avoid abrupt changes in your lifestyle. I found the book fascinating and eminently useful.

An interesting aspect of using the Spend ‘Til the End book is that you can enhance its functionality by using ESPlanner, a software tool developed by Lawrence Kotlikoff, an economist and one of the book’s authors. I have previously written more about ESPlanner and other retirement portfolio analysis tools.

If you are interested in learning more about Spend ‘Til the End, click the Amazon link above. That will take you to a page where you can look at book excerpts and reviews.

Photo Credit:  night86mare

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