Consumption smoothing is what EvolveMyRetirement® is all about. But just what is it? Here’s the definition from Investopedia: “Consumption smoothing is the practice of optimizing our standard of living by ensuring a proper balance between spending and saving during the different phases of our lives.” That’s easier said than done. It certainly can’t be done by guesswork; even less so by no planning at all.
Simplified consumption smoothing
Even without the uncertainties of the future, consumption smoothing is a hard problem. If you spend too much before you retire, you’ll need to reduce your standard of living in retirement. If you spend too little before you retire, you’ll die without having enjoyed life to the full. There are many complicating factors including:
- The desire to leave a legacy
- Choosing your age of retirement
- Multiple sources of income and fixed spending
- Taxation
We need to make fixed assumptions about inflation, interest rates and investment growth rates. It’s then possible (though difficult) to calculate a discretionary spending rate at which you die leaving exactly the desired legacy.
The problem is: the calculation will be wrong, because fixed assumptions are always wildly wrong.
The real problem
In our simplified problem we ignored uncertainty. But in the real world we need to take many uncertain factors into account, such as:
- Life expectancy
- Inflation
- Interest rates
- Investment growth
- Risk versus reward
- Annuities versus drawdown
Once we add these uncertainties into the problem, consumption smoothing becomes far more complex. In fact there is almost never a guaranteed optimal level of spending. For nearly everyone, every strategy has a particular risk of failure. The appropriate balance of risk against reward depends on our personal risk tolerance.
Traditional consumption smoothing means ensuring a constant standard of living throughout our life. With uncertainty in the mix, we also have to choose whether to modify our standard of living in response to unfolding events; or to stick with our original strategy come what may. Most people would tend to be flexible, so planning for it can make sense.
The number of variables is so large that we need advanced modelling techniques to cope with them. Fortunately, we built our Consumption Smoothing Calculator, using such advanced techniques. Even though its underlying technology is highly sophisticated, it’s easy to use.