What is Consumption Smoothing?
EG
Summary:
Consumption smoothing is the concept of allocating your resources in a way that allows you to maintain your spending power over your lifetime, rather than living paycheck-to-paycheck.
A recent study by OnePoll and AmeriLife found that roughly 70% of Americans report living paycheck-to-paycheck. This number is troubling, to say the least. Not only does it affect people’s spending power today, but this also limits whether they can respond to a future event or financial emergency and even their ability to retire.
That’s where consumption smoothing comes in. This financial strategy helps to allocate your income in a way that ensures that you can maintain your spending power over many years, and even during retirement. Keep reading to learn how consumption smoothing works, why it’s beneficial, and some roadblocks you might run into in the process.
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What is consumption smoothing?
Consumption smoothing is the practice of managing your spending to maintain the same standard of living over a long period of time. This financial process is designed to help you find a balance between spending for today and saving for the future. Not only does it consider periods of reduced or irregular income, but it also ensures a comfortable retirement.
How consumption smoothing works
Many people manage their budgets in a way that only considers their immediate financial obligations. Unfortunately, this paycheck-to-paycheck cycle can lead to financial hardship in the future. The idea of consumption smoothing is that you smooth out your resources over time so that you can maintain a similar level of discretionary spending.
Consumption smoothing has several key objectives that help address both short- and long-term financial goals.
- Short term. In the short term, this financial strategy helps to address emergency expenses that might come up in your budget. If you’ve saved appropriately, then you can manage those unexpected costs without them affecting your budget in the current month.
- Long term. Consumption smoothing can also be used as a longer-term strategy to address changes in income. There’s no guarantee that the amount we earn today will be what we earn a few months or a few years from now. In fact, plenty of people work in jobs where their income fluctuates throughout the year. Others may have seasons of life where they take a lower-paying job, or even leave the workforce altogether.
- Very long term. Finally, consumption smoothing helps to address the very long-term goal of retirement. Just as we want to maintain our standard of living five months or five years from now, we also want to maintain it during retirement. An important part of consumption smoothing is allocating a portion of your income to savings while you’re still working to help you enjoy a better lifestyle during retirement.
In this situation, consumption smoothing helps to level out resources over many months or years, so you’ll have a similar standard of living.
What is an example of consumption smoothing?
Suppose someone has an irregular income, some months earning $10,000, and other months earning $2,500.
Rather than spending everything they earn each month — and having a considerably lower living standard during other months — they would instead spend $6,250 per month. During the months they earn $10,000, they can save the remaining funds to use during the months when their income is lower.
The economic argument for consumption smoothing
The idea of consumption smoothing isn’t exactly new. The first example of this savings method dates back to the mid-20th century.
Then
Using the economic perspectives of John Maynard Keynes in the late 1930s, Franco Modigliani of MIT developed the life cycle hypothesis in the 1950s. This theory argued that people prefer to (and can) maintain a smooth living standard throughout different phases of life. Modigliani’s hypothesis explains the importance of saving during your prime earning years and, when your income is lower later in life, liquidating those savings.
A similar concept was discussed in 1957 by Milton Friedman in his paper “A Theory of Consumption Function.” In this paper published by the Princeton University Press, Friedman discussed the concepts of “permanent income” and “permanent consumption.”
Friedman hypothesized that people will base their current consumption on what they believe their future income will be. This idea of permanent income refers to the idea that people spread their consumption out over their lifetimes, rather than adjusting their spending at any given time based on their current income.
Now
Now, more than half a century later, financial experts still discuss the importance of allocating your resources to protect you, not only today but also in the future. These ideas are the basis of financial strategies, such as having an emergency fund and consistently contributing to a retirement account.
If you aren’t sure how much to contribute to your retirement account, it may help to speak with a professional wealth advisor. After reviewing your financial situation, your advisor can propose a contribution plan that best suits your retirement goals without ignoring your current finances.
The problems with consumption smoothing
It’s clear that there are benefits to consumption smoothing. But, like most things, there are also some problems that may arise.
Long-term consistency
First, over the long term consumption smoothing can be challenging, to say the least. Most people don’t think far in advance about their finances. While it’s easy to discuss how you’ll meet your immediate obligations while also saving for retirement this month, it becomes increasingly challenging the further out we look.
Over a lifetime, consumption smoothing relies on us consistently saving for retirement so that when we’re no longer working, we won’t have to sacrifice our standard of living. However, this depends on being financially able to contribute to retirement accounts throughout our working years, which isn’t always feasible for everyone. Even a relatively short period of financial hardship today could affect your plan for the financial future.
Irregular income challenges
Consumption smoothing can be difficult for some people, even in the short term. Many people earn a fairly consistent monthly paycheck that’s the same size, or at least close to it. Over the course of years, many people’s salaries don’t change dramatically, except to increase slightly as they advance in their careers.
For someone with an irregular income, properly allocating their spending throughout the year can be hard. A person might have a relatively high income during one month, but in another month bring home a quarter of that amount.
On the one hand, this is exactly the type of situation that consumption smoothing is designed to address. On the other hand, when your income is irregular, especially when you don’t know what your income will be each month, it becomes increasingly difficult to level out your financial responsibilities throughout the year.
Consumption smoothing and budgeting tools
It can be difficult to predict future consumption patterns. For folks with an irregular income, budgeting tools such as sinking funds can help you maintain financial stability. This is especially true during those months when your income is lower than expected, or if an unplanned expense hits your bank account.
FAQs
What causes consumption smoothing?
For most people, consumption smoothing doesn’t happen naturally. Instead, it requires careful budgeting and financial planning to make sure you’re properly allocating your resources.
Why is consumption smoothing important?
Consumption smoothing is important because it helps you maintain your spending power over time. Not only can you prepare for unexpected expenses and prevent yourself from falling into debt, but you can also start planning and saving for your dream retirement life.
What is perfectly smooth consumption?
Perfectly smooth consumption would mean spreading out your spending and savings in such a way that allows you to maintain exactly the same living standard for your entire life.
Key Takeaways
- Consumption smoothing is the practice of managing your spending in a way that allows you to maintain the same standard of living over a long period.
- This technique can help you break the paycheck-to-paycheck cycle, since you’re setting aside money for unplanned expenses and low-earning months.
- Ideally, you can use consumption smoothing as a long-term financial tool to help you reach a comfortable retirement by setting aside money during your earning years.
- Consumption smoothing may be more difficult for low-income or irregular-income earners. However, those are also the people who can benefit the most from it.
EG
Erin Gobler is a Wisconsin-based personal finance writer with experience writing about mortgages, investing, taxes, personal loans, and insurance. Her work has been published in major outlets, such as SuperMoney, Fox Business, and Time.com.
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