The Common Sense Rewards of Consumption Smoothing

“Consumption Smoothing” is a coinage only an economist could love. But like it or not, the concept of consumption smoothing is a mainstay of common sense. Indeed, our short-term economic lives are quite familiar with it. If money is tight and we get paid just once a month on the 15th, we learn to smooth our living standard so that in each of the month’s four weeks our consumption or discretionary spending is the same. That’s also called economic common sense.

So why don’t we apply this same common sense to our long-term economic lives? If we have job earnings, asset income, future Social Security and retirement income, a pension, and a mortgage that is paid off in five years—why don’t we just smooth out that present and future income and all those changing expenses so that our living standard remains constant each year over the rest of our lives? We don’t do it because it’s very difficult to do; furthermore, the prevailing retirement planning approach—despite common sense—uses the opposite approach.
The difficulty has to do with complex math—all of these numbers need to be converted to today’s dollars in order for them to make intuitive sense; inflation adjustments have to made, and future Social Security benefits have to be precisely calculated based on specific earnings history. These are just a few of the puzzle pieces. And it gets even trickier: it turns out there are multiple ways to solve the same lifetime consumption smoothing problem. Fortunately, years of economic research and a now an online calculator that ESPlanner provides for free can make these calculations so that our living standard, not our saving target, becomes the focus of the solution.

Let’s look at an example to show the power of this economic strategy.
Consider Jack and Janet’s economic picture:

• Income: 85K each with 3 more years of earnings (through age 64).
• Regular assets: 350K
• Age: both 62
• 401(k) Contributions: 4K each plus employer match (16K total)
• Mortgage: 5 years remaining, 50K balance
• 401(k) balances: 400K each (800 total)
• Pension: Janet, 2K annual with no survivor benefit, adjusts for inflation
• State Taxes: Missouri

Determining this couple’s discretionary spending or “consumption” takes just 30 seconds with ESPlanner. Jack and Janet can spend $76,657 each year in today’s dollars every year from their current age, 62, through age 100. Taxes, housing, saving, Medicare Part B, and Social Security all change over time. Nevertheless, the couple’s consumption is calculated to remain constant. This approach is very different from conventional financial planning that asks us to save a constant amount and let lifetime living standard ride the roller coaster.

So that’s valuable information to have. Jack and Janet now know one solution to the problem of creating a smooth, sustainable living standard. Instead of saying to themselves—“we’ll be better off when the mortgage is paid off five years from now”—they can rest assured that their living standard is smooth and that their saving or withdrawal from saving can be adjusted each year into the future to keep things at this optimal, sustainable level.

When seen in action, consumption smoothing looks like a kind of mathematical magic trick. Most people would be pleased just to see how all of these variables interact, all the while producing a solution to the puzzle that makes smooth consumption, not saving target, the outcome. But there are more rewards to using consumption smoothing—the ability to do real life option analysis and the ability to raise that living standard just by optimizing or making more efficient use of one’s available resources.

Jack just lost his job! He’s 62. His plan was to work until age 65, take Social Security, and then begin the 401(k) account withdrawals. Without a job, he now has no labor income, he is no longer contributing (or receiving the match) to his 401(k), and there’s no additional earnings contributions to Social Security. Family taxes will go down, but that’s not by itself going to solve the problem. Jack and Janet are in panic mode. It seems all of their retirement plans are dashed. “What does this mean for our plans?” they ask.

First let’s take Jack and Janet’s economic temperature. Their new sustainable living standard is $70,079. That’s $6,578 per year lower for each year from age 62 through 100. That’s 8.5% lower than what they had. Can they lower their living standard $548 per month from $6,388 per month to $5,839? Well, perhaps so. For some, that amount represents a new car payment which might be a sacrifice they are willing to make.

But this consumption smoothing calculator can also optimize their available resources, so let’s put it to work for them. If they both postpone their Social Security benefit to age 70, they make better use of their future resources and thus they can sustain an annual, inflation adjusted consumption of $74,216. That’s just $203 less each month than what they had prior to Jack’s job loss. “Hmm, maybe things are not so bad as we thought,” Janet replies. “I don’t mind my job so much. In addition, what if I plan to work just one extra year?” That too is an easy calculation for ESPlanner. Add an additional year of earnings and all that this entails for taxes, Social Security, and the 401(k) and their new smooth living standard is $76,683. “That’s more than we’ve been living on!” Jack shouts. They huddle. They smile. Problem solved.

Using a consumption smoothing approach is not just for economists. Indeed, it’s a common sense way to approach planning for the future. Every 10-year old learns how to smooth her allowance and make it last through the week. But given the scale of a family’s lifetime economy, this is impossible without a planning tool designed for that purpose. We have the tool. It’s free. Let common sense prevail and use it to solve real-life problems.