Count on parents to think long-term. Though curiously uninterested in whether you have beer money for next week, they’re apt to harass you about saving for retirement, “while you’re young.” Should you worry?
Here’s what a financial advisor would tell you: the earlier you start saving, the less you need to save. That’s the power of compound interest. Our generation may need to depend on personal savings in retirement, once aging baby boomers and benefit-averse employers have shredded our pension systems. But what would economists recommend?
If there is an economic theory of retirement savings, it is the “permanent income hypothesis” or “life cycle model,” independently developed by both Franco Modigliani and Milton Friedman. Imagine that you want to maintain a steady standard of living throughout your life. When you are young, you make little or no money. Over your lifetime, your income increases, until retirement age, when it drops off to zero. For your consumption to remain level over your lifespan, you should borrow money while you are young, saving more as you progress through middle age.
Until recently, this model accurately predicted most people’s behaviour, but recent studies suggest baby boomers are deviating from the path, saving less during middle age. Maybe this is where our parents’ advice comes from: we haven’t saved enough, but our kids can avoid our mistakes.
A small group of (admittedly controversial) economists have suggested that boomers may be saving too much, sacrificing current happiness to fund expenses they won’t actually face in retirement. Others have noted that it is in financial planners’ interests to encourage excess saving. “Those very same financial planners earn money only to the extent you save,” says Tyler Cowen, prominent econ blogger and professor at George Mason University.
Then there are the more radical suggestions. Ian Ayres and Barry Nalebuff, maverick profs at Yale, recommend that we start leveraging our investments at age 25. That’s right: they think you should borrow money to invest for retirement. Ayres and Nalebuff argue that this reduces risk, because it lets you diversify your investments not only between companies and industries, but across time. With 90 years of stock market data simulating their strategy, the professors found that imaginary investors did twice as well as they would followint the strategy advocated by financial planners.
The fact is, if you start saving right out of university, you will likely follow some version of this strategy, thanks to student loans. By saving while also in debt, you are already borrowing money to save it. The interest accumulated on your loans probably won’t outweigh the returns on low-risk investments. (Do note that if your employer matches your saving, or the tax deduction associated with investing knocks you down into a lower income bracket, that might make the difference.) Ayres and Nalebuff are advocating relatively risky investments, which can outrun the interest on a loan. As far as I can tell, no one has yet followed their advice. You could be the first. Now what would your parents say to that?
