Life-cycle finance

The objective of life-cycle finance is consumption smoothing. Households wish to spread their resources over their lifetime to maintain a consistent living standard. This means saving for retirement while one is working, or spending less than they earn so that they can later spend more than they earn after work stops. It also means using insurance to help smooth spending in face of the uncertainties related to health, disability, and death.

The living standard to be smoothed is on a per person basis. Families with young children can expect to spend more in total than empty nesters. And there are economies of scale, as living together helps to reduce total expenses relative to what one person would expect.

People seek to smooth spending over their lifetimes in order to obtain the greatest satisfaction from their limited resources, and the problem to be solved is how high this standard of living can be. Because salary, household composition, taxes, mortgage payments, and so forth, vary so dramatically over a household's lifecycle, trying to target basic rules of thumb related to replacement rates, wealth accumulation targets, savings rates, or withdrawal rates, can end up causing more harm than good.

For example, savings rates generally do not need to be fixed at some level, as it is the spending level which should be fixed. Savings (or dissavings) is what remains after accounting for all income and expenses in any given year. This creates a real disconnect as most of the discussion regarding retirement deals with rules of thumb which are anathema to practitioners of lifecycle finance.

Differences between life-cycle and mean/variance approaches
For at least the last 35 years financial economists have approached personal investing from the life-cycle finance point of view. Most financial advisors and investment enthusiasts approach personal investing loosely from the mean/variance approach to investing that was developed by financial economists in the 1950s and 1960s. Many decades ago in financial economics that approach was superseded by the life-cycle approach, which treats the earlier mean/variance approach as a relatively unrealistic special case of the life-cycle approach to personal investing.

While there is a lot of overlap, there are also some significant differences between the two investment approaches. Life-cycle finance is much more goal focused than the older method.

Take retirement planning goals. In the conventional approach the goal is to maximize expected financial wealth in your targeted retirement year, given how much you are willing to save, and how much investment risk you can tolerate. From the life-cycle point of view, the overall goal of retirement planning is to have roughly the same standard of living in retirement as before retirement. Therefore the retirement financial goal is to have reliable retirement income that sustains your standard of living.

The way the income goal is usually framed is by pricing real annuities that supply the retirement income target and not by applying arbitrary rules like 4% of financial assets at retirement converted to income every year. A stress is put on having two income goals. One is the aspirational income goal and the other is a lower floor income goal that is constructed entirely from relatively safe assets such as SS, DB pensions, life annuities, and TIPS and I-bonds.

Another key difference is how risk is managed, which is implicitly alluded to in the above aspirational and safe income goals. In the older conventional framework investment risk is almost entirely managed thru diversification. In the life-cycle approach all three risk transfer methods (hedging, insuring, and diversifying) are used without particular stress on diversifying. In other words the life-cycle approach relies explicitly on both matching strategies and the conventional diversification strategy in managing investment risk. Additionally, in the conventional framework risk is hardly ever approached thru a state price approach, but the state price approach to risk is often used in life-cycle finance. Risk strategies that rely on hedging and insuring are called matching strategies because they match assets to liabilities. Risk strategies based on diversifying are simply called diversification strategies. See: Investment risk management for additional details and representative examples. State price: In financial economics, a state-price security is a contract that agrees to pay one unit of a currency if a particular state occurs at a particular time in the future and pays nothing in all the other states. The price of this security is the state price of this particular state of the world.

In short, the risk in risky assets tends to show up at the worst possible times. Thus you don't want to fund your financial future betting on risky assets and nothing going wrong with the economy or your health. Instead you should have a combination of risky financial assets, relatively safe financial assets, and insurance so that regardless of the future financial state you actually live in, you have a reasonable chance for an acceptable financial life. See: Re: Free Stanford Course: Finance of Retirement & Pensions, by bobcat2.

The practical idea here is that when planning our financial future we want to think of possible likely states of our world and how we will address these contingencies. We might in the next few years be in good health, but we could be in poor health. We might be fully employed with big salary increases, but we might become involuntarily unemployed. How do we intend to address each of those possible states of our financial world? Life-cycle finance incorporates this point-of-view, which was first developed by Kenneth Arrow in the 1950s, that an investor should consider alternative future outcomes and the amount of consumption obtained in each possible situation. See: Re: Wade Pfau: Lifecycle Finance, by bobcat2.

Quantitative analysis also has a different emphasis. Go to a conventional financial advisor and he will often talk about Monte Carlo simulations of the portfolio. Go to an advisor steeped in the life-cycle approach and she will analyze the problem, at least informally, through the lens of dynamic programming.

Introductory articles
Nationally there are perhaps only two dozen financial planners that follow the life-cycle approach rather than the conventional approach based on the older MPT paradigm. Probably the best known of these planners is Paula Hogan, who is based in Milwaukee. Paula has written several articles on the differences between the conventional MPT approach and the life-cycle approach. Her articles are very accessible to lay readers, which is something that can't be said of many of the papers by economists written on life-cycle household economics.

Here are links to several of Paula's articles that discuss these two approaches to personal finance and highlight the differences.

Here are articles by three prominent economists on the life-cycle approach which are accessible to investment enthusiasts.

The first is from Robert Merton, one of the fathers of life-cycle economics, writing in the Financial Analysts Journal. The second is by Larry Kotlikoff writing in the Journal of Financial Planning. The third is Zvi Bodie's paper from 2002. In addition there is Bodie's short companion piece to this article,


 * Thoughts on the Future: Theory and Practice in Investment Management, January/February 2003.
 * Economics' Approach to Financial Planning, November 2007
 * Life-Cycle Finance in Theory and in Practice (April 2002). Boston University School of Management Working Paper No. 2002-02. Available at SSRN.
 * A Note on Economic Principles and Financial Literacy (April 2006). Networks Financial Institute Policy Brief No. 2006-PB-07. Available at SSRN:

Also, you may want to follow William Sharpe's life-cycle blog - RetirementIncomeScenarios. Oddly enough, Sharpe has a second blog cite devoted to life-cycle finance, this one is titled Lifetime Finance.

A recent entry is Sharpe once again discussing the obvious deficiencies of SWR rules.
 * RetirementIncomeScenarios
 * Lifetime Finance

Books and papers
This list of books and papers on life-cycle economics is generally a little more advanced than the above list, but for the most part fairly accessible to the interested general reader.

Papers and articles
In 1985 Franco Modigliani won the Nobel Prize in Economics primarily for his pioneering work on the life-cycle hypothesis. In many ways he is the father of life-cycle economics.

The theory of life-cycle economics in its modern state began with companion papers by Paul Samuelson and his student Robert Merton in 1969.

These papers brought rigorous dynamics into Modigliani’s life-cycle hypothesis. Samuelson’s paper dealt with the discrete time case using stochastic dynamic programming. Merton dealt with the more difficult case of continuous time using optimal control methods to deal with continuous stochastic variation.

These early papers used advanced math techniques and later research relies on math that is more advanced than these methods. While the math to prove these things is difficult, the underlying ideas are fairly intuitive.

What makes this difficult is the dynamic nature of these problems. The decisions I make this year affect this year’s outcome and next year’s decisions, and next year’s outcome. This continues to play out this way for every year of my life from now until when I die.

Vol. 51, No. 3 (Aug., 1969), pp. 239-246from jstor.og. Enable cookies to view.
 * Lifetime Portfolio Selection By Dynamic Stochastic Programming, Paul A. Samuelson, The Review of Economics and Statistics


 * Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case, Merton, Robert C, 1969, from RePEc(Research Papers in Economics).

There have been many papers since these 1969 papers that have updated and refined the connection between human capital and the life-cycle model. In particular the best known and most influential of those papers, "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model", by Bodie, Merton, and William Samuelson (Paul's son) written in 1992.
 * Bodie, Zvi and Merton, Robert C. and Samuelson, William F., Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model (January 1992). NBER Working Paper No. w3954. Available at SSRN: http://ssrn.com/abstract=420291

The economic literature on household life-cycle economics over the last 40 years is voluminous, but the above is a good start. Life-Cycle Economics is pretty central to the modern economics of the household and the consumer. Seven Nobel prize winners are on these lists of authors. In every case their work on life-cycle economics was a core portion of their research.