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: LCHAlternate 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: 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: 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 doesMake poor financial decisions with the money they receiveHave 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.
