Life Cycle Economics And The Safety First Strategy

Well-read retirees will no doubt recognize the terms "Safety First" and "sustainable withdrawal rates (SWR)". "Safety First" refers to a retirement-spending strategy in which retirees first cover their essential retirement spending needs with assets that have no stock market risk and only then invest in a risky portfolio. SWR or "the probabilist school" as it is sometimes referred includes a strategy primarily based on stock market returns to fund both essential and non-essential retirement spending. The 4% Rule is a probabilist strategy.

The Safety First school is based on well-established Life-Cycle Economics theory that can be traced back to the early 1950's work of Franco Modigliani and his student, Richard Brumberg.Zvi Bodie, Jonathan Treussard and Paul Willen wrote a discussion paper for the Boston Federal Reserve entitled, "The Theory of Life-Cycle Saving and Investing" that is far more accessible than the relevant economics literature.[1] Still, a lot of us checked out of ECON 101 the first time the professor said, "marginal propensity to consume" so I imagine there are many of us who could use a little extra help.

The authors identify three principles for applying the life-cycle theory to financial planning.

  1. Principle one tells us to focus not on the financial plan itself but "on the consumption profile that it implies.” Consumption equals income less savings during our working years and withdrawals from savings less health expenses in retirement.

  2. Principle two says to view our financial assets as vehicles for moving consumption from one location in the life cycle to another. We can move consumption from our high-earning years to retirement by saving.

  3. Principle three says a dollar is more valuable to an investor when consumption is low. A dollar of income is more valuable to us when we are unemployed, for example, than when we have a high-paying job.

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