What is the life cycle hypothesis?

The Life Cycle Hypothesis (LCH) is an economic theory suggesting that individuals have a tendency to maintain a consistent level of spending over time. They achieve this goal by borrowing when they are younger and have a lower income, saving during their middle years when their income is higher, and living off their assets in their later years when income decreases again.

Definition and Examples of the Life Cycle Hypothesis

The life cycle hypothesis posits that households save and spend their wealth in an effort to maintain a stable consumption level over time. Although wealth and income may fluctuate throughout your life, the theory suggests that your spending habits remain relatively constant.

A good example of this is saving money for retirement. You learn that your income may dwindle as you age, so you save money during your working years to afford the same lifestyle later on.

How the Life Cycle Hypothesis Works

The life cycle hypothesis predicts that you generally maintain the same level of consumption throughout your life by:

• Borrowing money when you are young (either by taking out loans or liquidating existing assets)
• Saving more money when you are in your middle years and at the peak of your career
• Living off the wealth accumulated when you have retired and no longer working

It is important to note that the life cycle hypothesis predicts that your saving habits follow a moderate peak pattern, as illustrated in the graph below, where the saving rate is low during both your younger and older years and peaks during your middle years:

Young: $10 – Consumption: $15 – Saving from Income: -$5 – Wealth at End of Life: -$5

Middle Age: $30 – Consumption: $15 – Saving from Income: $15 – Wealth at End of Life: $15

Older: $0 – Consumption: $15 – Saving from Income: -$10 – Wealth at End of Life: $0

For example, let’s say you earn $20,000 this year, but you expect your income to rise to $80,000 next year because you have a guaranteed job after graduating from college.

According to the life cycle hypothesis, you may spend money today with your future income in mind, which could lead you to borrow money. When you reach the peak of your career, you will pay off any debts you have accumulated and increase your savings. Then, you will draw from these savings during retirement so you can maintain the same level of spending.

Critiques of the Life Cycle Hypothesis

Although the life cycle hypothesis may stand the test of time, it is not without its flaws:

• The life cycle hypothesis does not take into account unexpected financial windfalls
• Traditional applications of the life cycle hypothesis do not apply to individuals facing irregular financial benefits throughout their lives
• For example, the life cycle hypothesis may assume that NFL players save large sums of money during the peak of their careers so they can sustain the same level of consumption when they retire
• However, the reality is that some NFL athletes go from extreme wealth to almost poverty after their sports careers end
• A study conducted by the National Bureau of Economic Research in 2015 predicted that NFL players have a 15% to 40% chance of bankruptcy within 25 years of retiring
• The study indicated that high bankruptcy rates may be due to the fact that players believe their careers will last longer than they do, make poor financial decisions with the money they earn, and face social pressures to spend more than they should
• It assumes

The life cycle hypothesis suggests that your level of consumption will remain relatively stable by borrowing money when income is low and saving when income is high. However, this is not always realistic.

For example, younger workers may not have access to the credit needed to fund their ideal level of spending right now. Therefore, it’s natural for their consumption habits to change as their income increases and these options become available to them.

Similarly, a family consisting of parents in their thirties with three young children and student loan and mortgage debt may consume more now than they will in their seventies when they are retired and possibly debt-free, not reliant on dependents.

Life Cycle Hypothesis vs. Permanent Income Theory

Both the life cycle theory and the permanent income theory seek to understand how individuals spend and save money. The main difference is that the life cycle hypothesis relies on a limited timeframe, suggesting that a person saves enough to maintain spending habits throughout their life. In contrast, the permanent income theory is based on an infinite timeframe, positing that a person saves enough to sustain current spending habits while leaving what remains for future heirs.

The Takeaway

The Life Cycle Hypothesis (LCH) is an economic theory that describes how an individual maintains the same level of consumption over time by saving when income is high and borrowing when income is low. The life cycle hypothesis predicts that wealth accumulation follows a peak-shaped curve where the savings rate is low during youth and old age and peaks during maturity. However, the hypothesis faces criticism due to the instability of individual consumption over time and its inapplicability to individuals facing irregular income changes or unique financial circumstances.

Sources:

• Massachusetts Institute of Technology. “The Collected Papers of Franco Modigliani, Volume 6.”
• Federal Reserve Board. “A Primer on the Economics and Time Series Econometrics of Wealth Effects,” Page 8.
• Carnegie Mellon University. “The Life Cycle Theory of Consumption,” Page 340.
• National Bureau of Economic Research. “Bankruptcy Rates Among NFL Players With Short-Lived Income Spikes,” Page 8.
• Centre for Economic Studies and Finance. “Working Paper No. 140: The Life-Cycle Hypothesis, Fiscal Policy, and Social Security,” Page 7.

Source: https://www.thebalancemoney.com/what-is-the-life-cycle-hypothesis-5209285