6♥ – Keep it Smooth

Keep it Smooth - Spread your consumption evenly to reach FI quickly

Keep it Smooth

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

Keep it Smooth – Spread your consumption evenly to reach FI quickly

Today I’m going to try to persuade you to spread your consumption evenly through your life.

We’ll look at:

  1. the theory behind keeping it smooth
  2. whether people actually do it in reality
  3. how you might approach it if you think you can give it a go

So what is Keeping it Smooth? It’s just my slightly less academic term for what economists call consumption smoothing.

This is an approach to money which tries to strike a balance between:

  1. the human desire to maximise immediate consumption (see also “high standard of living”, lifestyle inflation” and “keeping up with the Joneses”) with
  2. the desire by some of us to accumulate sufficient assets that we can have a secure retirement (and if we’re really lucky, and that retirement can begin before we reach the state-sanctioned age of 66+

The idea is that you spend the same amount during the accumulation phase (when you are working) as during the decumulation phase (when you are retired).

So how do you work out how much to spend?

  • Well, as with every other bit of planning, you start at the end.

The calculation comes in two stages:

  1. You work out how much you need to live on in retirement
  2. You work out how big a pot you need to produce that income every year
  3. You work out how much you need to save each year to produce that pot
    • There’s a bit of flexibility in this step since you can save more to reach that pot size early, or save a bit less to reach that pot size a little later
    • You can use our Four Pot Solution spreadsheet to work out how much to put into a SIPP, an ISA and a workplace pension to retire by a particular age
  4. Then you subtract these contributions from your post-tax income, and – hey presto – that’s the amount of money you have to live on right now

That’s your basic Savings Rate / Retirement Age calculation – Stage One of the CS calculation – over with.

Next, you compare the money you have to live on with your annual budget for outgoings – you do have an annual budget, don’t you?

If your spending money is less than your budget, something needs to change.

  • You either need to earn more or to spend less (now)
  • Or you could retire later, or live on less in retirement
  • Our page on Budgeting could help

If your spending money is more than your budget, you can move forward to Stage Two of Consumption smoothing.

  • I will assume here that your current budget for outgoings is more than your planned spending in retirement
  • If not, go away and fix that – at the very least they should be equal

Try reducing your current budget and increasing your retirement spending.

  • Play around with the Four Pot Solution to see what that does to your retirement age
  • Hopefully, it moves it forward a bit.

Then you repeat this trial-and-error process until you have a current budget that matches your retirement spending, and produces a retirement age that you are happy with.

  • You have now Smoothed Your Consumption.

Of course, not everyone will be hardcore enough to flatline their expenses over 50 years or more.

  • As a result, there are a few variations to full-on consumption smoothing (CS).

There are four ways in which you can move closer to consumption smoothing without going the whole hog:

  1. where you start from
    • if you have a current budget that is much higher than your retirement spending, then you might want to cut it back over several years rather than in one big go
    • you would then increase your savings over the same period
  2. temporary additional spending
    • it’s also possible that you might have some temporary extra expenses
    • school and university fees for your children are probably the classic examples
    • some people also choose to account for paying down the mortgage on their house in this fashion ((Note that taking out a mortgage when you are young and repaying it before you retire is in itself a form of consumption smoothing ))
    • this works just like option one, in that you reduce your budget (and increase your savings) at some point in the future, rather than today
  3. the very young
    • most people’s incomes will rise during their twenties and peak somewhere between age 35 and age 50
    • for some people in their twenties, they won’t yet be earning enough to defer spending in order to smooth their consumption
    • the goal for them is to avoid borrowing so much to improve their lifestyle in the short-term that they will be unable to take advantage of consumption smoothing later when they are earning more
  4. spending less in retirement
    • finally, there are those people who are certain that they can’t spend as much in retirement as they do now
    • full Consumption Smoothing isn’t appropriate for these people
    • that doesn’t mean that playing around with the numbers won’t result in a better mix of current spending, retirement spending, and retirement age
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These are all fine approaches – it’s your money, after all.

Here’s an example of consumption smoothing that isn’t fine.

  • In West Africa and India, many poor families pay door-to-door collectors a fee of 30% to 40% a year to look after their money.

When I first read about this ((In the Economist, back in 2009 )) it seemed very strange, but in today’s climate of negative bond yields and negative deposit rates, it seems less so.

  • But it’s still wrong.

The idea here is that since the incomes of these families are not only very low but also irregular, it is better for them to restrict access to their own cash so that they smooth their consumption out into the future rather than “blow their wad” in the week they receive it.

  • I have nothing against this in principle, only against the negative rates. ((It’s also not clear to me how the collectors can guarantee the safety of the deposits since their identities must be known locally ))
  • It does provide an income for the collector, but that’s not enough to offset the usurious rates.

A term deposit account at a local credit union – with a positive interest rate – would have the same effect without impoverishing the families involved, but I assume there is nothing like that in the areas involved.

  • So could standing orders paid on the same day a salary hits a bank account, but many of the poor are unbanked, and must create their own solutions.

Now for a bit of theory.

  • Consumption Smoothing is closely related to the Permanent Income Hypothesis (PIH), invented by Nobel Prize winner Milton Friedman in 1957.

This states that people have an inbuilt preference for consumption smoothing, and would naturally prefer to stick as closely as possible to their average consumption over a lifetime – what they think of as their “permanent” income that is safe to spend. ((This is true of myself, but not many people who I know – it assumes for a start that most people have some idea of what their average lifetime consumption might be ))

The example usually given is that most people wouldn’t immediately spend a one-off windfall, but would save it for a rainy day. ((This bodes ill for helicopter money – should it ever arrive – unless it is time-bounded ))

  • If on the other hand, you got an unexpected salary rise, that might indicate that your long-term prospects had improved.
  • You might start to spend a bit more (this is lifestyle inflation).

So do people actually behave like this in practice?

Surprisingly, they do, but mostly over the short term.

  • Many people are good at budgeting to spend their salary over or a month, or to pay for holidays or Xmas over a year.

Where people are not so good – as with so many things in finance – is over the long-run.

This is partly because of human psychology – we have an immediacy bias and think that the future will take care of itself – and partly because we think that the calculations involved will be too difficult.

  • This was true until recently (see the third section of this article for details on how to work out what your level of consumption should be).

At first, studies supported the PIH, but by 1990 economists reckoned that only about half of consumers uses CS, with the rest living “hand-to-mouth”.

See also:  2♥ --- The Best Time to Start is Now

The recent academic evidence is that people don’t smooth their consumption.

  • People do spend windfalls (like the Alaskan annual bonus from natural resources)
  • In theory, when their income goes down, they spend less, often by deferring purchases of large-ticket items like cars and new kitchens ((In fact, in 2006, a paper found that many people actually consume more when interest rates are high – this makes no sense except for people with lots of cash on deposit; everyone else would be paying more interest on their debts ))
  • There is some smoothing of non-monetary consumption, since once you are living in your own house it will take a lot to get you out of it

To be fair to the PIH, it’s often tested somewhat out of context, in a simplified form:

  • what it actually says is that consumption (and in particular, changes to consumption) is / are difficult to predict, since they depend on individual expectations (of the future permanent income)
  • what is usually tested is whether people spend the same amount when their income goes up or down

Of course, it’s hard to rigorously test a theory that says you don’t know what to expect.

So what, you might say.

  • Some old economist ((Famous to anyone who lived through Thatcher’s government, but probably unknown to the young )) had a theory that didn’t work out (probably).

Why should I care?

  • Well, probably you shouldn’t – just get on with looking after your own affairs.

But the PIH has implications for government policy and finance:

  • in particular for things like helicopter money, as I hinted in a footnote above, but for fiscal stimulus in general – if people obey the PIH it may not work
  • this is because it may not start the “multiplier effect” from increased consumer spending – what is required instead is a change in consumers’ expectations about their future income

It also suggests that people will pay a lot (ie. too much) for financial assets that have good returns during recessions since this will support consumption smoothing.

And finally, most academic macroeconomic models – including the ones central banks use to decide on interest rates – are based on “consumption Euler equations” that match to the PIH.

  • So if PIH is wrong, so is a lot of government policy.

I guess we’re coming back again to the idea that people aren’t necessarily as rational as economic models would expect them to be, and even rational behaviour depends on possibly irrational expectations of the future.

  • This is bad news for economists (and governments) but great for the rest of us.
  • If we can stick to being rational, we can prosper.

Lecture over, back to the practicalities.

I hope you can see that consumption smoothing makes sense over the long-term.

  • Whatever people in general are doing – and the evidence is mixed – you should seriously consider CS.

Saving for retirement is – like most things in finance – a balancing act

  • Taking the time to understand your saving and spending requirements, and working towards smoothing them out over time should lead to a better standard of living overall.
  • But striking this balance is a major challenge in financial planning.

CS is not that easy to stick to, nor is it easy even to work out the exactly the right thing to do (though that has become much easier in recent years)

  • But getting it exactly right isn’t crucial
  • Even if you only move half-way towards CS, you’ll be doing yourself a favour in the long run.

So remember, Keep it Smooth – spread your consumption evenly through your life,

  • so that you can to reach Financial Independence as quickly as possible.

Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 39 years, with some success.

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6♥ – Keep it Smooth

by Mike Rawson time to read: 7 min