According to the life-cycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime?
The life- cycle hypothesis helps to explain the habits of individual spending and saving. The hypothesis explores a typical pattern for individual saving over their lifetime in relation to debt and expenses. The life- cycle hypothesis asserts that spending increases in the early years of one's working life and at the end of one's life in retirement. At these two points, consumption habits are their highest. The hypothesis asserts that in the early years of one's working life a great deal of expenses and debt is incurred. The generating of income is not as strong in the early years of working, and thus greater need to consume is evident. At the same time, while it might be a stated priority, the hypothesis makes the case that savings is not something that can be generated with ease because of the inconsistent and unequal income status and needs. For this reason, spending and consuming habits in the early years of working take priority over savings.
Towards the apex of one's working years, the hypothesis asserts a greater propensity to develop paths that enable savings. In the midst of one's working years, income stability is present. At the same time, there has been a greater chance to pay off debts from earlier years. Additionally, the recognition of retirement as something distinct helps to create a plan for savings. As income earnings rise, so does the planning for retirement. Savings is most displayed at this point. The hypothesis asserts that as income production rises in both quantity and stability, savings also increases. The individual's savings pattern is integrated into their consumption pattern. Towards the end of one's life, retirement puts aged individuals on a fixed income. It at this point where the life cycle hypothesis argues that the consumption aspect of one's economic habits increase. Savings were geared towards this point in one's life and thus there is consumption of said savings. According to the life cycle hypothesis, as income declines, savings are used to sustain the individual in the latter stages of one's life. The life cycle hypothesis would argue that the overall savings rate from a national point of view would be balanced out. The savings generated towards the middle of one's life would be offset by the spending in the latter stages of one's life. Thus, the savings rate in the overall economy would be canceled out by the dissaving. If the individual aggregate savings would be offset by dissaving, then this would translate to a national level.
The challenge present is that research might suggest that the life cycle hypothesis's assertion about dissaving in the latter stages of the consumer's life could be revisited. Studies have shown that individuals who live off of their savings are more frugal and do not spend so freely to ensure that no savings is evident. Rather, they recognize that there is a lack of generated income and thus are more likely to embrace saving habits understanding that their income is finite and not constructed as a zero sum quantity. Realities such as health care related costs compel the retired individual to not so freely spend their savings, preventing the net- zero savings rate. It is in this where one might see an increase in overall savings and not the habits of spending offsetting those of spending.
According to the life-cycle hypothesis, an individual’s saving patterns over his or her life time resemble a bell curve. There is little saving (relatively speaking) when people are young, a great deal of saving when they are in their middle age, and very little or no saving once again when they pass retirement.
When people are young, they are less likely to save for at least two reasons. First, they are not typically making as much money as they will later make. This means they have less disposable income to invest. Second, they do not feel that saving is very urgent. They are decades away from needing the money that they save and have fewer incentives to save.
When people are in middle age (broadly defined), both of these factors change. People are typically making higher incomes in these years. They also feel the proximity of retirement much more and realize they cannot put off saving.
Once people retire, of course, saving drops dramatically. Many retirees do not have the income needed to save. They have to live off of their savings and therefore do not continue to save. Of course, some retirees will have income, but this is much less common than with people in their prime working years.