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How to Use Consumption Smoothing to Plan for Retirement

If You Save, You've Engaged in Consumption Smoothing

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The idea behind consumption smoothing is that we all want to maintain our standard of living throughout our life. Meaning we don’t want to go through a period of time of being poor, then rich, then poor again. Nor do we want to get gradually poorer as we retire.

To avoid these cycles, each year you have to figure out how much you can spend and how much you need to save so that you can continue to spend the same inflation adjusted amount later when you are no longer working. If you save at all today, you are engaged in some form of consumption smoothing.

Inputs Needed to Smooth Consumption

In order to accurately calculate what it will take to maintain a stable living standard you need to look at:

  • Taxes today
  • Taxes later when you take withdrawals
  • Other sources of income such as Social Security and pensions
  • How different types of savings are taxed
  • Age differences between spouses
  • Inflation
  • Potential rates of returns on savings
  • Expenses

Are You Saving Enough?

If you are not saving enough (meaning you are spending too much) then you have to decide to either work longer or spend less. Spending less accomplishes two things: it means you save more now while you are working, and it means you need less savings to maintain the same standard of living once you are no longer working. It is useful to use software to determine if in fact you are saving enough, or in some cases, saving too much.

Learn more: Simple Secrets to Save More.

Software to Use for Consumption Smoothing

Larry Kotlikoff, Professor of Economics at Boston University is known for his work on life-cycle consumption smoothing and has software designed to show you what to spend vs. save in order to maintain your highest sustainable living standard. Out of all the free retirement calculators I have looked at, I have found his free ESPlanner Basic software to provide the most accurate analytics, as it allows for far more personal and detailed inputs than other free programs.

Learn more: See Wade Pfau, CFA, Ph.D. in Economics commentary on ESPlanner and Consumption Smoothing

But, Is a Dollar Today Worth More Than a Dollar Tomorrow?

One of the questions that comes up when discussing consumption smoothing among academics is something referred to as a utility function. That’s a fancy way of saying, is $1 of spending today worth more than an inflation adjusted $1 of spending in the future?

Most of us place a higher value on money in hand today than money we’ll have available to us in the future. This can make it challenging to impress upon people the importance of saving for tomorrow.

What About Inflation?

From an economist view point, what everyone should want is to maintain an inflation-adjusted standard of living now all the way to age 100. Unfortunately, many people are not willing to save enough of their current income to accomplish this. They have decided that spending today is more important.

Learn more: Inflation in Retirement and What You Can Do About It.

This means trade-offs are necessary when retirement age nears. Perhaps the goal will be to maintain a fixed amount of income, but this income may not keep pace with inflation. In essence, this means your dollars will gradually have less and less purchasing power as you age. If a dollar today is worth more to you than a dollar when you are 85, this trade-off may be acceptable.

The bottom line is you’ll feel more secure as you accumulate more savings, and consumption smoothing is just a fancy technical way of explaining that.

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