Editor's Note: This story originally appeared on NewRetirement.
Consumption smoothing is a financial planning concept developed and tested by economists.
It refers to the somewhat aspirational idea that people strive to maintain a relatively stable and predictable standard of living over their lifetime through all phases of life.
There is a lot that can happen over a lifetime – by design or chance. Consumption smoothing is the ideal that you can live the life you want in a wide variety of circumstances or conditions and regardless of fluctuations in spending and income.
To reduce uncertainty, people often choose to give up spending power in the short term and instead save or purchase insurance to mitigate future risks or changes in income.
It is about figuring out a path through life that optimizes a balance of spending, saving and earning.
It is not wise to overspend and put off saving for retirement and then have to work longer or reduce your standard of living as you age. Nor is it desirable to over save and live a meager lifestyle while working and not ever get to enjoy oneself.
Consumption smoothing aims to stabilize for an optimal standard of living.
Consumption smoothing is not necessarily about spending the same amount every day for the rest of your life. Your spending needs will vary from year to year.
For example, you may experience spending spikes for things like college costs or medical expenses. And, your spending may actually decrease significantly if you slow down in the future.
Your income, particularly your earned income, will also vary tremendously over your lifetime, particularly in retirement when you cease to work.
Consumption smoothing is actually a common practice for short-term spending.
Most people get paid once every two weeks. And, you may balance eating out on Friday with an inexpensive meal another night. But, it is typical to try to spend roughly the same amount each week. And, most people have an intuitive ease with cash flow that enables this to happen.
You understand how much you have to spend each pay period and you keep to those parameters (give or take).
When you do this, you are engaged in consumption smoothing.
Consumption smoothing over your lifetime is vastly more complicated than monthly budgeting. And, far fewer people do it successfully. It requires a written plan, complicated calculations, and the ability to see far into the future.
Typically, people who have and act on a long-term financial plan are engaged in consumption smoothing.
The NewRetirement Planner is ideal for visualizing and optimizing for consumption smoothing. The tool enables variations in income and spending and allows you to try out different strategies for maintaining your desired lifestyle.
One way to understand consumption smoothing is to think of it as financial machinery. The machine is supposed to produce a stable lifestyle and you have four main levers to accomplish this goal:
Work Income: The money you earn, which will likely vary greatly over time.
Spending: The money you spend, which will also likely vary greatly over time.
Assets: Savings and other assets that can be tapped when work income does not cover expenses.
Financial Products: Investments, debt, insurance, and other financial products can all also be deployed to help stabilize your lifestyle.
For example, insurance is used to help spread out the cost of a potential event that could dramatically impact your lifestyle.
And, mortgages spread out the cost of your home and are one of the best tactics used for consumption smoothing. When you buy a home with a mortgage, you are borrowing money to help you achieve a quality of life much earlier than if you had to save to buy it with cash.
Younger people typically rely most heavily on levers like work income, debt, and reduced spending to establish their lifestyle. Retired people live almost entirely off assets — savings as well as benefits like Social Security and even home equity — accumulated over their lifetime.
Another way of understanding consumption smoothing is to think about your finances not as a monthly inflow and outflow, but rather as a big reservoir of resources that you fill up or drain over your entire life. Think in terms of the lifetime value of your financial decisions rather than simply how it impacts you today.
You see, in life, you have a finite amount of time to create a finite amount of money. That money is used to fund your entire life. Spending more now means that you have less to spend later. Saving more now means spending less in the near term, but more in the future.
Creating and maintaining a detailed retirement plan is a great way to visualize and manage your financial reservoir over your entire lifetime.
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