Consumption Smoothing and Your Financial Future

by Michael on Oct 23, 2013 · 5 comments

Image of an Electronic Wave

In response to my recent post about estimating the true cost of ongoing spending, a reader (and blogger) named Edward said:

On the flip side, I’m on track to have a fully funded retirement when I am ready to retire. Why forgo a pleasure now to have more money than I need in the future?

I tend to agree. Believe it or not, it’s okay to spend money. And yes, this is true even if we’re just talking about wants as opposed to needs.

The key is to strike a balance, and to be mindful of these decisions. If you’re on track to hit your savings targets over your desired timeframe, then you officially have my permission to go spend money. 😉

What Edward is really hinting at is an economic concept known as consumption smoothing, which involves balancing your saving and spending throughout your life to maintain an even (and as high as possible) standard of living over time.

So you’re essentially trying to avoid both over-saving and over-spending.

If the case of the former, you’ll live an overly austere life in the early years only to wind up with more wealth than needed later in life. Not a terrible problem, but you could’ve loosened up and enjoyed yourself more along the way.

If the case of the latter (which I think is a more common problem), you’ll have an artificially high standard of living in the early years at the expense of your golden years. The end result will be delayed retirement and/or a greatly reduced standard of living late in life.

As attractive as this idea (i.e., consumption smoothing) sounds, it’s easier said than done. Figuring out exactly how much you need to save (or can spend) across different life stages is a very complex endeavor. And the stakes are quite high.

Related: Scott Burns has a good (if dated) book on the topic.

In my view, this is a potentially useful concept, but one that should be approached with caution. I say this because it’s all too easy to use the consumption smoothing worldview to postpone saving until some distant day in the future.

Yes, you’ll be able to save more money once the kids are on their own, but you’ll also have missed out on years (and years!) of compounding. Maybe it’s better to aim high and then just bail out earlier if you end up overshooting the goal.

1 Kurt @ Money Counselor October 23, 2013 at 6:37 pm

The thing that always comes to mind for me when I read interesting discussions like this is breaking the connection between spending money and having fun or enjoying life. A key to controlling spending AND having a high-quality, luxurious, meaningful, interesting life is changing your mindset away from “if I’m not blowing money I can’t be doing what I really want to do!” Also cultivating friendships with people who don’t have to spend a lot to have a great time is crucial. If all your friends go clubbing three times a week, maxing out that IRA may be tough!

2 Michael October 24, 2013 at 8:14 am

Kurt: Excellent, excellent point. So excellent, in fact, that I had to repeat the word! 😉

3 Edward Antrobus October 23, 2013 at 10:35 pm

Thanks for the mention and expanding on the point I was trying to make. I think that many pf bloggers put too much emphasis on saving. The only reason to save money is to be able to spend it later.

4 Chris Peplinski October 24, 2013 at 5:27 pm

Good article. I just loosened up my over-saving to go on a family vacation once a year. I was finally talked into enjoying some of the hard-earned money we’ve saved. From now on, we’re going on one $5,000 family vacation per year! (Of course I’ll continually try to save on everything so the total is under $5k).

5 thepotatohead October 29, 2013 at 10:25 pm

I agree with being able to spend reasonably throughout your life. My main focus at this point in time however is getting my retirement savings on auto pilot. I was just able to get to the point where I can save enough each month to max out a 401k. Next goal is to max out the 401k and a Roth IRA. After that’s funded I’ll be more willing to spend “spare” money each month, as long as its reasonable.

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