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♪ [music] ♪

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- [Narrator] What is 
the lifecycle theory of savings?

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It's the theory about how a person
chooses to spend and save

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throughout her lifetime.

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But before diving 
into these choices,

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we need to examine 
a person's typical income over time.

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Most people's incomes don't stay flat
their entire lives,

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they change in predictable ways.

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Here's a typical pattern
showing a person's income

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over their life with their income
on the vertical axis

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and time on the horizontal axis.

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When you're young 
and still in school,

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you might make 
a little bit of money

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waiting tables 
or occasionally mowing lawns.

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Your first job out of school --
it's going to pay a lot more.

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After a few years of experience,

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and hopefully 
a few raises along the way,

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you make more than you ever have.

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Then, as you age, 
you look forward to retirement

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when your income falls,
but you're no longer working

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and you could really 
enjoy your golden years.

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Now let's imagine 
if your consumption followed

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the same path as your income
and you never saved or borrowed.

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You'd struggle when young,

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and you'd be unable 
to invest in an education.

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Then, you'd spend 
every cent you make

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during your prime working years.

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Well, that sounds like a lot of fun,
but without any savings,

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your income will drop suddenly 
when you retire,

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and so will your consumption.

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Your golden years 
wouldn't be so golden.

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So instead people tend to 
follow lifecycle theory of savings.

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A person can start out consuming 
more than she makes,

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borrowing to fill that gap,

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and to pay for things 
like an education.

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Then during her prime working years,
she makes more than she consumes,

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paying down her debt
and saving the extra income

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for retirement,
and when retirement comes,

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she can spend those savings 
and enjoy the golden years

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even without working.

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We call it "dissaving,"

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but that just means 
spending your own savings.

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Now, of course, many people deviate

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from this exact path,
depending on details.

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They consume less in college
than they do as professionals.

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Ramen noodles are no longer 
are a staple of my diet,

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but generally speaking, 
many people follow a pattern

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of borrowing, saving and dissaving

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to smooth their consumption path 
over their lifetime.