By Robert Powell
Most financial planners advise young people to start saving early — and often — for retirement so they can take advantage of the so-called eighth wonder of the world: the power of compound interest.
And many advisers routinely urge those entering the workforce to contribute to their 401(k), especially when their employer is matching some portion of the amount the worker is contributing. The matching contribution is — essentially — free money.
New research , however, indicates that many young people should not save for retirement.
The reason has to do with something called the life-cycle model , which suggests that rational individuals allocate resources over their lifetimes with the aim of avoiding sharp changes in their standard of living.
Put another way, individuals, according to the model which dates back to economists Franco Modigliani , a Nobel Prize winner, and Richard Brumberg in the early 1950s, seek to smooth what economists call their consumption, or what normal people call their spending.
According to the model, young workers with low income dissave; middle-aged workers save a lot; and retirees spend down their savings.
The just-published research examines the life-cycle model even further by looking at high- and low-income workers, as well as whether young workers should be automatically enrolled in 401(k) plans. What the researchers found is this:
1. High-income workers tend to experience wage growth over their careers. And that’s the primary reason why they should wait to save. “For these workers, maintaining as steady a standard of living as possible therefore requires spending all income while young and only starting to save for retirement during middle age,” wrote Jason Scott, the managing director of J.S. Retirement Consulting; John Shoven, an economics professor at Stanford University; Sita Slavov, a public policy professor at George Mason University; and John Watson, a lecturer in management at the Stanford Graduate School of Business.
2. Low-income workers, whose wage profiles tend to be flatter, receive high Social Security replacement rates, making optimal saving rates very low.
Middle-aged workers will need to save more later
In an interview, Scott discussed what some might view as a contrary-to-conventional wisdom approach to saving for retirement.
Why does one save for retirement? In essence, Scott said, it’s because you want to have the same standard of living when you’re not working as you did while you were working.
“The economic model would suggest ‘Hey, it’s not smart to live really high in the years when you’re working and really low when you’re retired,’” he said. “And so, you try to smooth that out. You want to save when you have relatively high income to support yourself when you have relatively low income. That’s really the core of the life-cycle model.”
But why would you spend all your income when you’re young and not save?
“In the life-cycle model, we are assuming you are getting the absolute most happiness you can out of income each year,” said Scott. “In other words, you are doing your best at age 25 with $25,000, and there is no way to live ‘cheaply’ and do better,” he said. “We also assume a given amount of money is more valuable to you when you are poor compared to when you are wealthy.” (Meaning that $1,000 means a lot more at 25 than at 45.)
Scott also said that young workers might also consider securing a mortgage to buy a house rather than save for retirement. The reasons? You’re borrowing against future earnings to help that consumption, plus, you’re building equity that could be used to fund future consumption, he said.
Are young workers squandering the advantage of time?
Many institutions and advisers recommend just the opposite of what the life-cycle model suggests. They recommend that workers should have a certain amount of their salary salted away for retirement at certain ages in order to fund their desired standard of living in retirement. T. Rowe Price , for instance, suggests that a 30-year-old should have half their salary saved for retirement; a 40-year-old should have 1.5 times to 2 times their salary saved; a 50-year-old should have 3 times to 5.5 times their salary saved; and a 65-year-old should have 7 times to 13.5 times their salary saved.
Scott doesn’t disagree that workers should have savings benchmarks as a multiple of income. But he said a high-income worker who waits until middle age to save for retirement can easily reach the later-age benchmarks. “Savings for retirement probably is more in the zero range until 35 or so,” Scott said. “And then it is probably faster after that because you want to accumulate the same amount.”
Plus, he noted, the home equity a worker has could count toward the savings benchmark as well.
So, what about all the experts who say young people are best positioned to save because they have such a long timeline? Aren’t young workers just squandering that advantage?
Not necessarily, said Scott.