Financial planners often recommend that people save as early as possible to experience the power of compound interest. In the U.S., for example, advisers encourage those just starting to use a 401(k) retirement plan, which is named after the number of the country’s tax code article.
This plan is an alternative to a basic state pension, under which employees contribute to individual retirement accounts, and employers can also contribute certain amounts to employee accounts. And while the plan has the obvious benefit of early savings, there is research that finds these savings inappropriate.
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Hypothesis
The study that says people should not save for retirement is based on a hypothesis proposed by Franco Modigliani with Albert Ando and Richard Brumberg. This theory won Modigliani the Nobel Memorial Prize in Economics.
The hypothesis assumes that a person allocates their income between consumption and savings depending not on their current earnings, but on all resources over. And the savings a person makes in times of higher income can be carried over to periods when income was lower.
Based on this hypothesis, rational people allocate resources so as to avoid dramatic changes in living standards. According to this model, retirement is the main cause of income declines, so saving for old age should be a key goal of long-term savings.
Why shouldn’t you save?
Why shouldn’t people take care of saving ahead of time? The fact is:
- If your profession involves a high income, your salary will increase throughout your career. At the beginning of the road earnings will be lower — and with the savings it is better to wait.
- If your position is low-paying, there are no career plans and your current standard of living suits you, you need to first deal with what social guarantees in retirement will provide you with the state.
Why does the money go away?
According to the researcher, the model suggests that a certain amount of money is more valuable when you are less wealthy, meaning that $1,000 at age 25, at the start of your career, means more to a person than at age 45.
The more time you have, the more likely you are to accumulate more?
The conventional wisdom is that people are more successful at saving: they have the advantage of a longer distance. Scott suggests that this is not necessarily true: while saving with interest will increase your capital in the future, you should not forget such an economic term as time preference.
Both compensate for each other, so success depends on which is more meaningful. According to the researcher, time preference usually prevails. Also, you have to be thorough in your calculations: the strength of compound interest will not matter if interest rates are 0 in the face of inflation.
Is not deferring risky?
There are risks. For people with small incomes, it reduces social benefits; for workers with high incomes, it’s an unforeseen reduction in income. Just for these cases, it is worth setting aside money — but it will not be savings for retirement, and the reserve savings in case of force majeure.
What’s the bottom line
- The hypothesis suggests that it is better to save during periods when you are earning more so that you can take advantage of the savings at a time when your income is down.
- While it’s thought that people have the advantage of a longer distance to save, it’s worth considering the time preference.
- It may make more sense for people to save for purposes other than retirement: buying a home, for example.
