What You Need to Know
- A new academic paper argues that most young people should not save for retirement.
- The paper assumes people prioritize smooth lifestyle and consumption patterns over wealth maximization.
- Advisors see the paper as food for thought, but they disagree with its conclusions and urge early savings.
As detailed on its website, the Journal of Portfolio Management Research strives to be the leading provider of independent financial research for all within the investment sector.
Launched in 1974, the organization seeks to bring forward some of the most prominent thought-leadership publications in the financial sector, including those that have, in the words of the organization, immeasurably changed the shape of the industry. Some of its biggest publications have included articles introducing or detailing the Sharpe ratio and the Black-Scholes model.
Now, a new paper published in the Journal seeks to question the common wisdom that it is almost always better for individuals to begin saving and investing for retirement as early as possible. This assumption, according to the paper’s authors, is so deeply baked into the mind of the typical financial professional that it seems almost beyond dispute.
However, according to the authors, the construction and analysis of a “lifetime savings consumption model” implies that most young people should not save for retirement. This conclusion is based on the assumption that rational individuals allocate resources over their lifetimes with the primary aim of avoiding sharp changes in their standard of living, rather than simply striving to maximize their total possible wealth.
The authors of the analysis include Jason Scott, managing director of J.S. Retirement Consulting; John Shoven, the Charles R. Schwab Professor of Economics at Stanford University; Sita Slavov, professor of public policy at George Mason University; and John Watson, a lecturer in management at the Stanford Graduate School of Business.
What the Model Says
The new analysis suggests retirement policy is often predicated on the belief that earlier saving is always better, thanks primarily to the power of compounding. This belief is used to justify the increasingly widespread practice of automatically enrolling workers in employer-sponsored defined contribution plans, the authors write.
But, according to the analysis, this assumption is often not evaluated against a meaningful benchmark. They suggest a reasonable benchmark would be a lifecycle model, in which rational individuals allocate resources over their lifetimes with the aim of avoiding sharp changes in their standard of living.
In running their analysis, the authors conclude that the lifecycle model implies that most young people should not, in fact, be saving for retirement.
According to the authors, most workers tend to experience substantial wage growth over their careers, and this is especially true for higher-income earners who will be more dependent on private savings to maintain their standard of living in retirement. For these workers, maintaining as steady a standard of living as possible therefore requires spending all income while young and only starting to save for retirement during middle age.
The analysis posits that low-income workers, whose wage profiles tend to be flatter, receive relatively higher Social Security replacement rates, making optimal early career savings rates very low. The paper further suggests low real interest rates make a front-loaded lifetime spending profile optimal.
Ultimately, the authors argue, the welfare costs of automatically enrolling younger workers in defined contribution plans can be substantial, even with employer matching. Among their concerns is that many young people end up taking on toxic levels of debt or making tax-inefficient withdrawals from savings to meet current spending needs, resulting in worse overall outcomes.
Reactions to a Contrarian Conclusion
Speaking with ThinkAdvisor about the paper’s conclusions, Amir Noor, director of financial planning at United Financial Planning Group, calls them “interesting and obviously not unfounded from a theoretical perspective.” But at the same time, Noor says, financial advisors can point to some obvious concerns about the findings.
“For starters, the paper seems to assume that, just because you have the capacity to become a high income earner in the future, it will actually come to pass,” Noor says. “I can tell you from the experience of serving clients that this is not always the case.”
Noor points to the example of a person who experiences a health care crisis that significantly derails their ability to work as anticipated. Or perhaps a person decides to prioritize the raising of a family or the maintenance of a low-stress lifestyle over earning the most money possible during their prime working years.
“I also find it hard to believe that lower income earners will just want to remain in that position forever, especially young people,” Noor says. “Many people who are low income earners earlier in their lives do not expect or hope to stay at that same income level throughout their lives.”
The authors of the study could not be reached for comment.
Paul Staib, principal of Staib Financial Planning, agrees with Noor’s take.