What, really, is personal finance? The words "personal finance" are ubiquitous, yet amorphic without meaningful context. Personal finance writers are normally focused on very specific questions and choices. "Our personal finance 101" begins in earnest with the life-cycle model because the model is the foundation of every personal finance question. The essence of the life-cycle model is how households can live the best life considering their resources, longevity and preferences. Let's illustrate it.
Samantha is 21-year old living in Texas with a full-time job earning $50,000 per year who plans to work until age 70. Samantha has a long prospective life-cycle ( we assume longevity to age 100). Samantha has a normal set of bills every month that are non-discretionary that includes rent of $1,000 per month, a car loan of $331/month for the next 4 years, a student loan repayment of $338/month for the next 10 years, and basic food, insurance, and utilities of $1,000/month. On an annual basis, that totals $32,438 for the time until the car loan is paid off as can be seen in Life-cycle model part A. Another six years and the student loan is paid off and at Samantha's age 31 her non-discretionary expenses revert to $24,000 per year. That procedes until Samantha turns age 65 at which time she will be responsible for Medicare part B premiums. Notice that in column C for Samantha's ages that the annual amount of $7,026 remains constant. That amount is the solution given by the life-cycle model to the question of how Samantha is given the best financial life. More on that in a moment.
You might look at $24,000 of non-discretionary spending at Samantha's age 33 and thirty years later at 63 and rightly conclude that there is no way that basic living will cost the same. The numbers in the table are in real dollars adjusted for the assumption of 3% annual inflation.
Now that we know Samantha's basic living expenses we can calculate how much money Samantha has for fun. The fun number is Samantha's living standard, her total of discretionary spending she can make this year and every future year in light of the fact that she has a certain income, must pay federal income taxes, and is assumed to have 80 years of life in front of her where the last 30 she would like to be retired, and supplements her savings with social security retirement benefits she would be expected to receive based on current law.
The Life-cycle model part B table shows the next five years of Samantha's life then from age 71 until her assumed end of life, age 100. We used the basic version of ESPlanner which is a terrific piece of free software that makes the calculations. Total income includes Samantha's wages and return on her savings (assumed to be 1%). All numbers are adjusted for 3% annual inflation. The total spending column includes non-discretionary and discretionary spending in each year. Taxes are federal income taxes according to current tax law. Annual saving (column E) is total income less total spending less taxes. Samantha started her first year with a savings account that had $2,345 so that column F represents the accumulation of savings plus investment interest adjusted for inflation.
What is special about the life-cycle model is that it solves for
the proper amount of discretionary spending that, based on the household's data and assumptions, is the living standard that is sustainable for an entire lifetime. Savings isn't required of Samantha by some arbitrary rule. The amount of savings is a result of thinking about Samantha's living standard over the entirety of her life. The living standard is the amount of annual spending that can be undertaken such that along with her income, any taxes and savings account balances will be constant until her end of life. The savings account balance is $0 at age 100. Samantha doesn't need any more money if she as at the end of her life, right? If Samantha's expectation was for a shorter life, then she could spend more each year. A longer life than age 100, and she would need to spend less. If Samantha wants to leave an inheritance that can be modeled, too. She doesn't need to die with $0, but should know if that is her choice that her living standard while alive must be lower.
The key result for Samantha is that her sustainable living standard is $7,026 per year. How should Samantha think about this year? That her discretionary spending should be $7,026. Surely, some assumptions this year will need to be changed in for the forthcoming year. And, that is what financial planning is about. Calculate, review, and update. Samantha happiest financial life is one that determines how to maximize her sustainable living standard.
Life-cycle model part A
Life-cycle model part B