In 1985, Franco Modigliani, an economics professor at MIT, won the Nobel Prize for a simple technique that squirrels know intuitively from birth. You have to squirrel away some nuts during times of plenty so you can survive during times of scarcity.
Modigliani looked at the income and expenses of typical people over the life span. He found that household income was sometimes more than sufficient to meet expenses and that at other times money was tight. Preparation during these times of surplus help families avoid going into debt when they must increase their spending.
Modigliani divided the life cycle into four distinct phases:
1. Before having children there is often a surplus of income.
2. While raising and educating children, there is often a deficit when the family is spending more than they are earning.
3. When children go out on their own, families often have a surplus again.
4. In retirement the surplus is small if it is there at all.
Saving during the two surplus periods is crucial to financial well-being later in life. Before the children arrive, squirrel away some money. When the children leave home, you get one last chance to save for retirement.
Here are seven financial life lessons from Modigliani’s analysis:
When you are starting out, don’t try to duplicate your parents’ lifestyle.
Most of today’s college graduates are ill prepared for the real world of financial responsibility. They never saw how their parents lived when they were first married and struggling. Consequently, they may base their after-school expectations on an upper-middle-class lifestyle.
If you are a young adult, you can’t afford more house than your budget will allow. If you spend 50% of your lifestyle expenses on housing, you will not be able to live proportionally on the rest of your income. Too much house is one of the most common mistakes young people make.
It is as though we can’t feel successful without immediately enjoying the lifestyle of our parents at the height of their careers. To decide how much house is enough, calculate what you can buy for 30% of your standard of living.
Save as much money as you can in your 20s
Early in your career, when the cost of basic needs is small, income often easily covers expenses, allowing the surplus to be used for savings, investment or added consumption. Many young people assume they are doing so well financially that they can simply spend their extra money on more stuff. They do not realize these years of plenty won’t last.
During this period, save and invest up to 50% of your disposable income for future expenses. Fully fund Roth accounts, and fund 401(k) plans to take advantage of any employer match. Save 10% of your take-home pay for future large expenses. Put an additional 5 to 10% into long-term taxable savings.
This advice is especially important for those who delay marriage until they are in their 30s. Don’t waste a decade of prime saving and investing. You owe it to yourself and your future family to store up nuts now.
Don’t just save: invest
You can’t afford to keep your money in cash or in a bank account earning very little interest because of inflation. If you had saved $100 in 1970, it would only have the buying power of $16.88 today. You need to earn a return that exceeds inflation. Fortunately, you can.
At 10% market returns, whatever you save and invest doubles every seven years. So $1 saved and invested at age 21 doubles eight times before age 70. At that rate of return $1 saved and invested grows to $128 in retirement. If you wait until age 49 to start, $1 saved and invested will double three times, growing to $8.
Although annual volatility is high, it decreases with a longer time horizon. Given a 50-year time horizon, the odds of your money experiencing a positive average market return are very good.
Put another way, for every seven years you delay starting to save and invest, you risk cutting in half your net worth in retirement.
Avoid debt while raising a family
Expenses multiply once children arrive. The one-bedroom apartment is replaced by a four-bedroom home with a mortgage. If expenses for food, clothing, medical, dental, clubs, camps and lessons aren’t enough, children have their own set of endless desires. The average cost of raising a child to age 18 in 2012 dollars totals about $300,000. After a third of a million dollars in payments, the balloon payment comes at the end when college expenses are often financed through student loans and additional mortgages. During these years, many couples wish they had not spent their pre-child surplus.
Families find it challenging to live within their means during this phase of life. But you can live more simply in order to live debt free. The difference between middle income and multi-millionaire is a few hundred dollars a month in saving and investing.
Stop telling yourself you will get your finances in order later
The average American family runs their financial affairs in such a way that if they were a publicly traded company, their stock price would plummet, the business would go bankrupt and the people in the accounting department would be taken away in handcuffs.
You can’t postpone financial faithfulness any more than you can postpone marital faithfulness. Your habits set your financial DNA, and habits are simply habit forming.
Many people mistakenly believe that life comes in three stages: learning, working and recreation. They think that until they are toward the middle or end of the working stage of life, they don’t need to worry about finances.
Everyone in America can save something. Whatever you save, the magic of compound interest produces incredible results. It is far preferable to know what you need to save than to arrive at retirement unprepared.
Get a retirement checkup before you turn 50
For most families, expenses drop significantly after children leave home. Although starting younger is ideal, these are the years when many families realize time is running out to prepare for their retirement and they seek professional financial advice. This period provides a second chance to save and secure a financially comfortable retirement.
If you are in this stage of life, you need to know exactly how much you must save to achieve a comfortable retirement. You don’t have the luxury of guessing at the appropriate savings rate.
Know your safe withdrawal rate in retirement
Retirement ideally finds the family with income adequate to continue their usual lifestyle. With sufficient assets and good asset management, income from savings and investments, pensions and benefits should cover retirement expenses.
During retirement it is crucial to know what rate of withdrawal is safe. Spend too much and you will run out of money. Be too frugal and you needlessly put a damper on the years you might be traveling and gifting. You must have the right asset allocation to provide enough growth for a long and prosperous retirement but enough stability to weather market upheavals. This is another juncture that does not allow for guesswork.
The lessons to learn from Modigliani’s work are simple: “Before the children arrive, squirrel away some money. When the children go out on their own you get one last chance to save for retirement!”