Smooth Moves

Greg Spears

WHEN I ASKED MY college class this spring how many had been taught personal finance before, just a single hand went up. That’s why I teach Franco Modigliani’s lifecycle hypothesis of savings to my behavioral economics class.

A brilliant student born to a Jewish family in Rome, Modigliani was awarded first prize in a national economics contest by Mussolini himself. Warned to flee Italy while he still could, Modigliani soon after booked a zig-zagging trip through Switzerland and France before landing in New York in 1939. He earned a PhD in economics at The New School for Social Research, then took a job at the University of Illinois.

During a long drive back from a conference on saving, Modigliani hit on the theory that would make his name. He reasoned that people would gain the greatest utility, or satisfaction, if their spending was stable or rose slightly over their lifetime. A drop in spending was unsettling and risky—as Modigliani had experienced as a refugee, when he was forced to sell books to make the rent.

Given this goal of steady spending, Modigliani thought the best approach to our financial life would be to save a fixed percentage of pay from the first day at work until retirement. Then we’d steadily draw down our savings, spending at the same rate we’d consumed during our working years.

“Far from acquiring wealth as an end in itself, the role of savings was to accumulate resources to spend later on,” Modigliani wrote in his autobiography, Adventures of an Economist. Invoking the story of Joseph in the Bible, Modigliani wrote that we should save “during periods of fat cows in order to transfer and consume them during periods of lean cows, with the aim of maintaining a stable average consumption over the course of one’s life.”

This might sound obvious today, but at the time Modigliani’s hypothesis suggested that saving should be a mass movement, not just something practiced by the wealthy with surplus income. This helped spur the creation of broad-based savings programs, such as IRAs and 401(k)s. For this and other work, Modigliani was awarded the Nobel Memorial Prize in Economics in 1985.

I tell my students that Modigliani’s approach to saving is the correct way to lead their financial life. But it also highlights how much economics has changed in the past half-century. Even though it’s the rational approach, it’s not the path most of us follow. In actual practice, Modigliani’s hypothesis has four or five problems we struggle to solve.

First, it assumes everyone has the willpower to save continuously. Some people never get the memo, and most of us don’t save in our 20s. We have more urgent priorities, like getting out to bars, finding a decent apartment and laying hands on a dependable car. If you lack these, you may never get a date—the paramount goal at that age.

Retirement? Forget about it. That’s a lifetime away.

This leads directly to the second problem—we overvalue the present and discount the future. If you get “hangry” waiting 10 minutes for dinner, you know how today’s needs dominate. By comparison, the groceries we’ll need for a month of dinners in 20 years have zero importance to us.

Third and fourth, people suffer from loss aversion and inertia. We can avoid loss—including the loss we’d feel by subtracting savings from our pay—by doing what comes naturally, which is nothing. When the question of retirement savings comes up, the ready answer is, “I’ll get to that later.” Inertia is the most powerful force in the economic universe.

Finally, in Modigliani’s day, economists believed that people were inherently rational. If you plotted the best course of action, it was assumed that people would naturally fall into line, like ants streaming into a picnic basket. This might be true of the sages in the econ department. But outside the academy, lots of people have lost their way financially.

By waiting years to begin saving for retirement, most of us start on the back foot. We need to save a high percentage of pay later on, or accept a loss of income in retirement. Either way, we’re violating Modigliani’s recommendation to smooth our spending. That’s when behavioral economics came to the rescue.

Drawing on insights from psychology, behavioral economists try to help us make better choices by anticipating our natural tendencies. Their most popular invention is the automatic 401(k), in which employers enroll new workers in the plan from their very first day. Workers can quit at any time but most stay put. Inertia is now working in their favor, not against them.

With automatic plans, 86% of workers under age 25 are saving for retirement, according to research by Vanguard Group, a major 401(k) plan administrator. This compares to 24% in 401(k) plans where the young set must enroll themselves. A change that large is seismic—almost unheard of—in the social sciences. If you get a response that big, the first instinct is to check the data for errors.

But it’s no mistake. Automatic plans have shifted the conversation because they take into account how we actually behave—and not how we should behave.

I included a question on Modigliani’s lifecycle hypothesis on this past semester’s final exam, and almost everyone got it right. Still, I hope my students have an automatic 401(k) at their first job. It’s best not to leave saving to willpower, especially in our 20s.

Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.

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