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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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My first job had a profit share plan. No pension, no 401(k), just a profit share plan. You were put in the plan upon full-time employment. You didn’t have a choice. In good years the company put 15% of your salary in the plan (you couldn’t make contributions yourself). We had a few good years so that was a plus. Later the company was purchased and the profit plans were rolled over into 401(k)s. Having the “involuntary” profit share plan for the first ten years of employment really saved me. I’m a big fan of involuntary savings. Let’s hope it becomes more widespread, along with mandated financial education in schools.
KEWEL!
My Gson is becoming interested in investments. I’m sending him this!
Thank YOU Sir Greg . . .
Lifecycle works in 401k plans “done right” where designed using auto enrollment, escalation, QDIA (applied perennially) and coupled with “liquidity without leakage, along the way to and throughout retirement” – levering fintech (21st Century banking functionality). Modigliani also believed in “liquidity without leakage”. Thanks. Jack
https://www.psca.org/news/blog/another-nobel-laureate-economics-who-was-focused-401k-plans-part-2-3
https://www.soa.org/globalassets/assets/files/resources/essays-monographs/financial-wellness/2017-financial-wellness-essay-towarnicky.pdf
After being drafted into our military (on my university graduation day), it didn’t take many years before I realized what a great pension I’d have if I stayed 20 yrs. While it’s not the life for everyone, the camaraderie in the military far outweighs anything I’ve experienced in subsequent employment. And behavioral economics should be a required course in all high schools. Nudge by Thaler and Sustein should be required readding.
It never ceases to amaze me how valuable the Humble Dollar is to bring new thoughts and reading material every day. Thank you Greg for bringing to our attention The Adventures of an Economist. I will check it out from our local library.
Great article! My parents were frugal and steady investors and it wasn’t lost on me that their middle class incomes did not prevent them from becoming millionaires even though they never earned six figures at any point in their lives, combined. But not everyone has that kind of role model. You are making a real contribution to your students’ lives by teaching them fundamental truths about money.
You cite the Bible to remind us that the primary purpose of wealth accumulation is not to become wealthy per se, but to provide necessary funds for lean times and ultimately for our retirement. I agree that the message is self evident, although certain folks who oppose capitalism don’t.
I think if a basic class in personal finance were a requirement for all high school students, they would all benefit. I would favor letting them run simulations for hypothetical single and married people earning various levels of income, to allow them to see for themselves how different levels of debt, different amounts of money invested, and the starting age for such investments affect long term outcomes. I think the math and equations should be kept to a minimum, and allow them to absorb the most important basics, such as “pay yourself first”, how to manage debt, and the power of compound interest.
I agree wholeheartedly with the need for automatic enrollment. I started my first real FT job when I was 25. I was underpaid and didn’t understand why I would elect to have more money withdrawn from my paycheck. But towards the end of the year, at enrollment time, my boss asked me if I was in the retirement plan. He explained that there was a 7% “free money” employer match, that growth was tax free, and I should do it even if I thought I couldn’t afford it. Of course, he was right. And this should be part of mentorship in general.
I think the absence of automatic enrollment is a major reason why so many retirees who worked for employers with 401(k) and 403(b) plans are in worse shape than those who have pension plans.
The Pension Protection Act of 2006 granted employers a safe harbor encouraging them to both automatically enroll workers into 401(k) plans AND auto escalate deferrals. Plenty of small employers don’t offer 401(k) plans (as they are very expensive to set up and maintain. However, traditional IRAs and Roth IRAs are available. Of course, people have to know they exist, make the effort to set one up, and then figure out how to “fund” them. Outside of Social Security, the US does not have a coherent retirement income policy at the federal level. Should be a bi-partisan issue but apparently it’s not (individual responsibility vs. the nanny state).
When I became eligible for the 401(k) plan at Forbes magazine, the treasurer called me — a junior employee who was maybe 24 at the time — and said I should sign up. It would be great if that sort of thing became standard practice at all companies.
Thanks for the history lesson, Greg. I never knew about Franco Modigliani. My 15-year-old grandson will soon be taking a half credit Economics class, so I will encourage him to do a little research on Modigliani. He’s very much into earning money to invest. I’m not sure yet about the saving for retirement part – lol.
Linda – A 15-year old with earned income (W-2 wages) is eligible to contribute to a Roth IRA (2022 max is $6000). If his wages in 2022 are $2,500, he can contribute all of it to a Roth IRA. Some parents/grandparent encourage saving in a Roth IRA by offering a super generous “matching” contribution…grandson invests $250 of the $2500 of earnings and grandmother matches with $2250 (a gift) to get to $2500. At 8% in 50 years, $2500 would be $117,254, at 10% it would be $293,477. An easy, very good read for anyone including a 15-year old is (in my opinion) Morgan Housel’s “The Psychology of Money.”
Great article Greg. We can certainly see all those behaviors at work today.
I especially liked the reference to the belief that people were inherently rational – if only.
That was me in my 20s, to be sure. Lucky that my new boss at my first career-caliber job sat me down and explained 401k saving and “the free money match” in that ancient era of opt in only participation (1989).