What Is the Life Cycle Theory of Savings?

♪ [music] ♪

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

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

throughout her lifetime.

But before diving
into these choices,

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

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

they change in predictable ways.

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

over their life with their income
on the vertical axis

and time on the horizontal axis.

When you're young
and still in school,

you might make
a little bit of money

waiting tables
or occasionally mowing lawns.

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

After a few years of experience,

and hopefully
a few raises along the way,

you make more than you ever have.

Then, as you age,
you look forward to retirement

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

and you could really
enjoy your golden years.

Now let's imagine
if your consumption followed

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

You'd struggle when young,

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

Then, you'd spend
every cent you make

during your prime working years.

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

your income will drop suddenly
when you retire,

and so will your consumption.

Your golden years
wouldn't be so golden.

So instead people tend to
follow lifecycle theory of savings.

A person can start out consuming
more than she makes,

borrowing to fill that gap,

and to pay for things
like an education.

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

paying down her debt
and saving the extra income

for retirement,
and when retirement comes,

she can spend those savings
and enjoy the golden years

even without working.

We call it "dissaving,"

but that just means
spending your own savings.

Now, of course, many people deviate

from this exact path,
depending on details.

They consume less in college
than they do as professionals.

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

but generally speaking,
many people follow a pattern

of borrowing, saving and dissaving

to smooth their consumption path
over their lifetime.