Here’s some good news for those of us worried that the fall in stock markets has cut our pension pots: new research shows that many of us need less income in retirement than we think.
Standard advice assumes that we’ll need a constant real income after we retire. Stanford University’s John Shoven and colleagues, however, show that this is wrong. In fact, they say, we should plan on our spending falling as we age. Which means the pot we need to retire on “could be dramatically lower” than advisers have assumed.
To see why, let’s think about the choice between spending now or saving so we can spend in future. In ordinary times, saving earns us interest so we can spend more later. But against this is the fact that we are impatient so prefer to spend now. A bit of maths shows that our optimum spending plan is the one that ensures that the marginal happiness (or utility) we get from spending today is equal to the marginal utility of future spending, raised by the interest rate but discounted by our impatience.
This tells us that our spending should be constant over time, if and only if, our impatience (or rate of time preference) is equal to the real interest rate.
Which it is not. Real interest rates are negative, and the yield curve tells us they’ll remain so for a long time. But the rate of time preference is positive. And there are good reasons why it should be, especially for those of us in middle age.
Quite simply, the marginal utility of consumption is likely to be lower when we are 80 than when we are 60, and not just because there’s a chance we won’t be around at 80. It’s because the satisfaction we get from spending is lower if we are unwell. If our mobility is restricted, holidays or nights out become less enjoyable. The author of the book of Isaiah was exaggerating when he wrote “let us eat and drink; for tomorrow we shall die”, but he had a point.
Professor Shoven and colleagues estimate that it’s reasonable to plan on our spending falling by a third between the ages of 65 and 85. Which of course means we need a smaller pension pot.
Coincidentally, this is how we actually do behave. Researchers at the IFS show that, on average, spending on non-durable items falls by an average of 2.2 per cent from the age of 45 to 79, implying that a 79-year-old spends only two-thirds as much as a 60-year-old. This is not because people run out of money. If this were the case, older people would be unhappy. But, on average, they are not. The ONS says that 65-79-year-olds are actually happier than others, especially the middle-aged – a fact which, says economist and academic David Blanchflower, is true for other countries too.
Now, you might object here that we cannot in fact plan our spending because we simply have no idea what our future health will be like, and if we plan on dying or suffering ill-health we’ll spend too much too soon and run out of money. This is true. But it only tells us that private pension provision is a bad idea, and the job would be better done by the state.
Even if we ignore health and mortality risks, however, there are good reasons why it would be sensible to plan on our spending falling as we age.
Some types of spending are in fact investments, in the sense that they build up a stock of capital that we can draw down later.
The thinking here dates back to a suggestion in 1977 by the Nobel laureates Gary Becker and George Stigler. They said we can build up a stock of consumption capital. The books and music we buy today will give us pleasure in future years as we grow to love them. Some of the best investments I’ve made have been in the novels of PG Wodehouse and CDs of Jolie Holland.
The point broadens. Spending on holidays and days and nights out give us a stock of happy memories to draw upon when we are less mobile. Alternatively, and more cheerfully, we can invest today in leisure skills which will help us spend our later retirement happily but cheaply. If you can cook well, you can save on expensive restaurant meals. And learning a musical instrument or singing now will give you cheap happiness for years.
It’s quite possible, therefore, that not only can many of us retire on less than we think, but that it’s sensible to budget for spending gradually falling. The pension fund industry’s claim that we need to save more for our retirement is, for many of us, plain bad economics. It has the same motivation as butchers’ claims that we should not be vegetarian, and the same intellectual content too.
