The recent rise in the personal saving rate has been interpreted as a sign that consumers are paying down their debt and repairing the damage done to their nest eggs. But a close analysis suggests that many people are falling short of saving what they will need to maintain their standard of living in retirement. A growing body of research in behavioral economics, a branch of economics that studies the choices people make at the individual level, offers explanations for why that is, as well as new approaches to the problem.
After steadily declining for many years, the personal savings rate began to reverse course in mid-1999, rising moderately as households struggled to rebuild their net worth in the wake of two events (figure 1). The first was the sharp decline in the stock market, which had a disproportionately larger impact on wealthier households. The second event was the bursting housing bubble, which had a disproportionately larger impact on households in the middle to lower end of the wealth distribution. Many of these households had borrowed heavily during the heady years leading up to the crisis.
Analysts have interpreted the increases in the savings rate since the crisis as a sign that consumers are paying down their debt and repairing the damage done to their nest eggs. But are they saving enough? This Commentary examines this issue in the context of the standard economic theory of saving. It finds that many households, if not most, are at risk of not having sufficient savings to retire. I offer several explanations for this shortfall.
Theory of Household Saving
The personal savings rate is a ratio of two measures -- personal savings and personal disposable income (take-home pay). Personal savings equals the amount of disposable income not spent on consumer goods and services (consumption). The measured personal savings rate is aggregated across households of different means and at different stages of their lives. For example, those in the formative stages of their households have more time to adjust to the impact of the recent crisis than those in or near retirement. The younger households can assume greater investment risk in hopes of earning higher returns. To more fully appreciate how such factors influence savings, it is helpful to work with a theory that identifies how behavior differs across one's lifetime.
The life-cycle hypothesis (LCH) is the most basic theory of household saving. It is based on the premise that households, or individuals more generally, make spending and saving decisions based both on their expected earning capacity over their lifetimes and on the investment returns they receive at different stages of life. A fundamental behavioral assumption of the theory is that households prefer to smooth their spending on goods and services over time. Figure 2 depicts a version of this theory that captures its key implications.
Note that the depicted household builds up net worth (wealth) relative to its income during the working stage of its life. Later on during retirement, if all goes as planned, they use the income derived from their accumulated wealth to support their anticipated lifestyle. Most often, at retirement they must also begin to sell from the stock of assets they acquired during their working lives. Depending on the household, they may wish to have some wealth when they die to bequeath to their children. This extra savings also provides a buffer if they live longer than expected.
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