Life-Cycle Hypothesis

The life-cycle hypothesis (LCH) is a theory of consumption and saving which holds that people try to keep their standard of living fairly steady over their whole lives. Because income is usually low early in life, peaks in middle age and falls in retirement, the theory predicts that people borrow or save little when young, save heavily in their peak earning years, and run down their savings after they stop working.

The hypothesis was developed by Franco Modigliani and his student Richard Brumberg in the early 1950s, and later tested with Albert Ando. Modigliani received the 1985 Nobel prize partly for this work. It is closely related to Milton Friedman's permanent income hypothesis: both reject the simple Keynesian idea that spending depends mainly on this year's income, and both stress forward-looking planning. The life-cycle model places more weight on age, retirement and wealth.

Think of a long road trip with one fuel card that has to last the whole journey. Some stretches have cheap gas stations along the way, others have none. A sensible driver does not race through the cheap stretch and then run dry; they fill up when fuel is easy to get so the car can keep moving at a steady pace to the end.

The life-cycle idea says people treat their working life the same way. They earn most in their 40s and 50s, so they set money aside then, mostly through pensions and home ownership, to keep living comfortably in their 70s and 80s when the paychecks stop.

In the simplest version, with no interest and no wish to leave a bequest, a person spreads total lifetime resources evenly over the years they have left to live:

• $C$ is annual consumption.
• $W$ is current wealth.
• $R$ is the number of working years remaining.
• $Y$ is expected annual labor income.
• $T$ is the number of years of life remaining.

A 40-year-old with savings of 100,000 who expects to earn 50,000 a year for 25 more years and to live another 40 years would consume $(100{,}000 + 25 \times 50{,}000) \div 40 = 1{,}350{,}000 \div 40 = 33{,}750$ a year. While working they save $50{,}000 - 33{,}750 = 16{,}250$ a year, and in retirement they spend 33,750 a year out of those savings. The model also implies that an extra unit of wealth raises spending only a little each year, which is the basis of the wealth effect.

The theory has several macroeconomic predictions:

• Demography shapes saving. A country with many workers relative to retirees will save more; as populations age and the dependency ratio rises, national saving should fall. This is one explanation offered for high saving in East Asia during its boom years and for concerns about future saving in Japan and Europe.
• Growth raises saving. In a fast-growing economy, younger working generations have higher lifetime incomes than older retired ones, so total saving exceeds dissaving.
• Pensions affect private saving. Generous public or employer pensions reduce the need for individuals to save on their own.
• Housing is a major channel. In many countries, paying down a mortgage is the largest single form of household saving, and older owners may draw on home equity in retirement.
• Temporary changes matter little. A one-off windfall or tax rebate spread over the remaining lifetime should raise annual spending only slightly, which weakens the multiplier from short-lived fiscal policy.

Household surveys broadly confirm a hump-shaped pattern of wealth that rises through working life. Several findings, however, depart from the simple model. Many retirees run down their wealth more slowly than predicted, which researchers link to bequest motives, uncertainty about how long they will live, and the risk of large health or care costs; the precautionary motive explains much of this. Spending tends to track current income more closely than theory implies, partly because many households cannot borrow against future earnings (liquidity constraints). Studies also find a drop in spending at retirement, which may reflect lower work-related costs but also inadequate saving. Behavioral economists add that people often lack the self-control or foresight the model assumes, which is why automatic enrollment in pension plans, a policy used in the United Kingdom since 2012 and widely in US workplace plans, has been shown to raise saving substantially. Supporters regard these findings as refinements rather than refutations: the model remains the standard framework for analyzing pensions, interest rates and saving in macroeconomics.

• Nobel Prize: Franco Modigliani, facts