A. The foundational concept with the life-cycle economics approach is “consumption smoothing” – the idea that households will generally prefer to maintain a steady standard of living throughout their lifetimes… which then leads them to save the “excess” during their working years in order to fund the deficits (i.e., retirement spending after there’s no more work income) in the later years.
Lifecycle finance focuses far more on the amount of life-time spending that can be sustained at any particular point, as opposed to focusing on more “conventional” measures like account balances/growth or Monte Carlo probabilities of failure. In addition, consumption smoothing is also much more complex in practice than “just” traditional approaches like saving a percentage of income in your working years to fund retirement, recognizing that income and the ability to save itself may be volatile over time (e.g., as kids are added to the household and constrain available dollars to save, and then eventually leave as parents transition to an empty nest stage with more disposable cash flow to save), and necessitating its own software tools (e.g., Larry Kotlikoff’s ESPlanner software or his more recent MaxiFiPlanner solution).
Other notable distinctions to the lifecycle finance approach in practice with clients includes:
- Risk capacity is measured not just by the ability to withstand a market decline, but how much “excess” the client can afford to invest above and beyond what it would take to simply buy a secure guaranteed income stream (e.g., via an inflation-adjusted annuity or a laddered TIPS bond portfolio);
- Retirement projections similarly tend to be built from a base of what it takes to secure income, and then adds a “risk premium” for investing over and above that amount (if clients want to take that risk);
- Insurance needs (both life and disability insurance) take on added importance by calculating exactly what is needed not just to “replace” income, per se, but ensure that it can still be effectively smoothed over life;
- Annuities tend to be more about the trade-off between secure retirement income and bequest motives, as opposed to just a psychological alternative for risk-averse clients who don’t want to invest in markets.