Consumption smoothing is a financial planning concept developed and tested by economists. This refers to the somewhat aspirational idea that people strive to maintain a relatively stable and predictable standard of living throughout all stages of life.
What is consumption smoothing?
Essentially, consumption smoothing refers to the practice of maintaining a constant level of spending or consumption over time, regardless of fluctuations in income or other financial sources. This strategy aims to cushion the effects of income fluctuations, unexpected expenses, or economic downturns, thereby promoting financial stability and resilience.
Although the concept of consumption smoothing has its roots in a variety of economic theories and studies, its formalization and prominence can be attributed to economists such as Franco Modigliani and Milton Friedman.
You’re probably doing consumption smoothing today for short-term spending
Consumption smoothing is actually a common technique for short-term spending.
Most people receive a paycheck once every two weeks. You can also balance eating out on Friday with a cheaper meal on another night. However, it’s common to try to spend about the same amount each week. And most people find it easy to intuitively understand the cash flows that make this possible.
You know how much you have to pay each pay period and stick to those parameters (give or take).
Doing this will result in consumption smoothing.
Applying consumption smoothing to long-term spending can be more difficult
Smoothing your spending over your lifetime is much more complex than creating a monthly budget. And far fewer people do it successfully. It requires written planning, complex calculations and the ability to see far into the future.
People who make long-term financial plans and act on them usually work on smoothing out their consumption.
NewRetirement Planner is great for visualization and optimization to smooth consumption. This tool allows you to make changes to your income and expenses, allowing you to try different strategies to maintain your desired lifestyle.
Financial levers that enable consumption smoothing
One way to understand consumption smoothing is to think of it as a financial institution. This machine is supposed to create a stable lifestyle, and there are four main means to achieve this goal.
Labor income: The money you earn varies greatly over time and may not exist for much of your retirement.
Spending: The money you spend can also change significantly over time.
assets: Savings and other assets that you can tap into when your labor income does not cover your expenses.
Financial products: Investments, debt, insurance, and other financial products can all be introduced to stabilize your lifestyle.
for example:
- Insurance is used to spread the cost of potential events that can dramatically impact your lifestyle.
- Mortgages are one of the best tactics used to spread the cost of housing and smooth consumption. When you buy a home with a mortgage, you are borrowing money to achieve a quality of life much faster than if you had to save up to buy a home with cash.
Practicing consumption smoothing over a lifetime
Young people typically rely the most on means such as labor income, debt, and cutting expenses to establish their lifestyles. Retirees live off almost all of the assets they have accumulated over their lifetimes (including savings and benefits such as Social Security and home equity).
Consumption smoothing emphasizes stability and does not aim to equalize spending or income levels.
Many things happen over a lifetime, either by design or by chance. Consumption smoothing is the ideal of being able to live the life you want under a variety of circumstances and conditions, regardless of fluctuations in expenses or income.
Consumption smoothing involves trade-offs
To reduce uncertainty, people often choose to give up spending power in the short term and instead save or take out insurance to reduce future risks and changes in income.
It’s about finding a life path that optimizes the balance between spending, saving, and income.
It’s not wise to overspend or put off saving for retirement, only to find yourself having to work longer or have a lower standard of living as you get older. It is also not desirable to save too much while working, leading to a poor lifestyle and not being able to enjoy yourself.
Consumption smoothing aims to stabilize the optimal standard of living.
Changes in spending
Smooth consumption does not necessarily mean spending the same amount every day for the rest of your life. Required expenditures vary from year to year.
For example, expenses can skyrocket due to college costs or medical expenses. And if the pace slows down in the future, spending could actually drop significantly.
Fluctuations in income
Your income, especially your earned income, will also change significantly over your lifetime, especially after you quit your job and retire.
A treasure trove of resources
Another way to understand consumption smoothing is to think about your finances. do not have rather than as monthly inflows and outflows. A treasure trove of resources It can be fulfilled or depleted throughout your life. Think about your financial decisions in terms of their lifetime value, not just how they affect you today.
As you know, in life, you have a finite amount of time to generate a finite amount of money. That money will be used for the rest of your life. Spending more now means spending less later. Saving more now means spending less in the short term and spending more in the future.
Creating and maintaining a detailed retirement plan is a great way to visualize and manage your financial savings throughout your lifetime.
Jump in! Start saving today with NewRetirement Planner.
