10 November 2020

---

Life cycle theory in new clothes

Author: Luigi Campopiano

---

When we talk about financial planning, one of the most famous and useful theories for understanding the importance of looking ahead is certainly Life Cycle Theory, presented by Franco Modigliani and Richard Bumberg in 1954.

Briefly, this theory, for which Modigliani won the Nobel Prize in 1985, postulates that people’s consumption choices must be considered over the span of the different phases of their lifetime: youth, work, retirement. According to Modigliani, a rational human being attempts to maintain a constant consumption profile throughout life, in order to maximize overall wellbeing. 

To do so, he or she must take into account the fact that the capacity to generate income and wealth varies greatly over one’s life span: when young, income-generating capacity is near nil, it rises over the working life, then, with the end of active employment, finally ceases. 

In Modigliani’s model, the work phase is the only one in which a surplus between revenue and spending is generated. In other words, it is the time in which Y (income) is greater than C (consumption) giving a difference S (savings) that should provide for the creation of wealth, capital. In the other two phases income is lower than consumption, so young people’s consumption is usually supported by their parents and older people, with declining incomes can find it difficult to face unforeseen expenses, such as the ones related to health problems. 

After this brief recap, we would like to discuss critically the applicability of Modigliani’s theory, in the present day context, 65 years on. What practical conclusions can we draw from this re-visitation. 

What has changed and how to interpret life cycle theory?

Many things have changed substantially over this period. In the Italian context, if we look at the demographic, social and economic situation, we cannot avoid considering the fallout on the financial plane. Italy has the lowest natality rate in the European Union, has had the greatest increase in longevity, a substantial shift from multi-member to single-member families, fundamental changes in working conditions, increased spending on health due to lack of self-sufficiency. These are but a few of the major aspects to take into consideration when reviewing the life-cycle model, now virtually obsolete and far from reality.

From a practical point of view, a few repercussions stand out:

• Increasing levels of education, together with a stagnant job market, are progressively postponing the passage from young to working phase. According to Eurostat, in Italy, young people leave home on average at 30.1 years of age: according to a study of the Visentini foundation, Italy is near the bottom of the league in Europe for inter-generational inequality (only Greece is worse off) and economic “independence” is predicted to be reached only at 40 in the near future. 

• The increase in precarious employment and the attempts to rebalance the social security system with the reform the pension system has prolonged working life and postponed the retirement age. In the 1980’s on average retirement was at 50, whereas in 2018 it was 61 for retirement and 68 for old age pensions. 

• In general, improved living conditions have lengthened life expectancy. Consequently, even the third and last stage of life is long. When life cycle theory was proposed, average life expectancy was 66, now it is 82. Even though this is a very positive outcome, it complicates matters by vastly increasing health costs, particularly acute care, that accompany an aging population.

These phenomena should automatically stimulate financial counter-measures. There is as yet a low perception of how the lengthening life cycle represents a serious problem, that if not adequately contrasted will have serious financial consequences.

We believe that one of the few valid ways to contrast this phenomenon is to increase the savings rate during the working phase. We will need more money to face the phases in which we are in deficit, both for bringing up our children and for retirement.

We cannot delay this fundamental concept, that can really make a difference to those who embrace it, but we do have one important ally: time. 

( Source: https://rpubs.com/)