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. Spending heavily before retirement may mean needing to adjust your standard of living later. Spending very little before retirement may mean missing opportunities to enjoy life earlier on. 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
Modelling typically requires fixed assumptions about inflation, interest rates and investment growth rates. It’s then possible to estimate a discretionary spending rate that would, under those assumptions, leave a specific legacy.
The problem is: such calculations are often inaccurate, because fixed assumptions rarely match real‑world outcomes.
The real problem
In our simplified problem we ignored uncertainty. Real‑world modelling involves many uncertain factors, 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 rarely a single spending level that can be considered optimal with certainty. 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. Many people prefer to remain flexible, so planning for that flexibility is common.
The number of variables is so large that advanced modelling techniques are often required to handle this complexity. Fortunately, we built our Consumption Smoothing Calculator, using such advanced techniques. Even though its underlying technology is highly sophisticated, it’s easy to use.