The life-cycle hypothesis (LCH) is an economic theory that suggests that individuals have a tendency to maintain the same level of spending over time. They achieve this goal by borrowing in when they're younger and their income is low, saving during their middle years when income is high, and living off their assets in their older years when income is low again.
Here’s a closer look at how the LCH works and why it’s important.
Definition and Examples of the Life-Cycle Hypothesis
The LCH states that households save and spend their wealth in an effort to keep their consumption level steady over time. Even though wealth and income may vary over your lifetime, the theory states, your spending habits stay relatively the same.
- Acronym: LCH
- Alternate name: Life-cycle model
Saving for retirement is a good example of the LCH in action. You know your income may disappear when you’re older, so you save money during your working years to afford the same lifestyle later on.
How the Life-Cycle Hypothesis Works
The LCH predicts that, in general, you maintain the same level of consumption throughout your lifetime by:
- Borrowing money when you’re young (either by borrowing money or liquidating assets you already own)
- Saving more money when you’re middle aged and at the peak of your career
- Living off the wealth you’ve accumulated when you’re old and retired
Franco Modigliani published the life-cycle hypothesis theory in 1954 with Richard Brumberg and later won a Nobel Prize for his economic analyses.
The LCH predicts that your savings habits follow a hump-shaped pattern as in the diagram below where your savings rate is low during your younger and older years and peaks during your middle years:
|Income||Consumption||Saving out of income||Wealth at the end of the age period|
For example, suppose you make $20,000 this year, but you expect your income will increase to $80,000 next year because you’ve got a job lined up after you graduate from college.
According to the LCH, you may spend money today with your future income in mind, which may lead you to borrow money. As you reach the peak of your career, you’ll pay off any debt you accumulated and ramp up your savings. Then, you’ll draw down that savings in retirement so you can continue your same level of spending.
Criticisms of the Life-Cycle Hypothesis
The LCH has withstood the test of time but it’s not without its flaws:
LCH Doesn’t Account for Financial Windfalls
Traditional LCH models don’t apply to individuals who run into financial windfalls or have sporadic income throughout their lives.
Take NFL players, for example. The LCH would imply that NFL players save considerable amounts of money while they’re at the peak of their careers so they can sustain the same level of consumption when they retire.
But the reality is that some NFL athletes go from enormously wealthy to near poverty shortly after the end of their careers. A 2015 National Bureau of Economic Research study that focused on LCH and the NFL predicted that an NFL player has a 15% to 40% chance of going bankrupt 25 years after they retire.
The study said the high bankruptcy rates may be due to the fact that players:
- Think their career will last longer than it typically does
- Make poor financial decisions with the money they receive
- Have social pressures to spend more than they should
LCH Assumes Your Consumption Level Will Stay the Same
The LCH predicts that you’ll maintain roughly your same level of spending by borrowing money when income is low and saving when income is high. But this isn’t always realistic.
For example, younger workers may not have access to the credit needed to fund their ideal level of spending now. So, naturally, their consumption habits would change as their income increased and those options became available to them.
Likewise, a family with parents in their 30s with three young kids, student loan debt, and a mortgage may consume more now than they will in their 70s when they’re retired, possibly debt-free, and no longer have dependents to care for.
Life-Cycle Hypothesis Theory vs. Permanent Income Hypothesis Theory
|Life-Cycle Hypothesis Theory||Permanent Income Hypothesis Theory|
|Published in 1954||Published in 1957|
|Works on a finite timeline that assumes an individual will only save enough to sustain their consumption habits during their lifetime||Works on an infinite timeline that assumes an individual will save enough to sustain their consumption habits now, while still leaving enough left over for their heirs|
|Assumes people only save money for themselves||Assumes people save money for themselves and their future descendants|
Both the LCH theory and the permanent income hypothesis (PIH) theory seek to understand how individuals spend and save money. The main difference is that the LCH is based on a finite timeline where a person saves only enough to sustain their spending habits during their lifetime. The PIH, on the other hand, is based on an infinite timeline where a person saves enough for both themselves and their heirs.
- The life-cycle hypothesis (LCH) is an economic theory that describes how an individual maintains roughly the same level of consumption over time by saving when their income is high and borrowing when income is low.
- The LCH predicts that wealth accumulation follows a hump-shaped curve where you have a low savings rate when you’re young, a high rate when you’re middle-aged, and a low rate again when you’re old.
- Some experts criticize the LCH because consumption doesn’t always stay consistent over time. For example, a middle-aged worker with three kids and a mortgage probably consumes more than they will when they’re retired with no debt or dependents.