Moorman and Company

Franco Modigliani, an American economist, won the 1985 Nobel Prize for financial economics with his contribution of the "Life Cycle"—an analysis of the behavior of household savers. While there is nothing new about the idea of a personal life cycle (Shakespeare pointed out there are stages to a person's life 400 years ago), Modigliani's model demonstrates how these stages affect a person's financial decisions.

For some time now, we have been using something called the "Wealth Cycle" to help us understand how we can make better investment choices throughout our adult financial lives. (For more information, see the August, 1992 edition of Financial Advisory). Now, we turn our attention to the "Life Cycle" in order to expand our self-knowledge to include the variety of other financial choices we make at different times (e.g., whether to save or spend, to be an employee or entrepreneur, to pursue philanthropic endeavors).

Just like with the Wealth Cycle, the ages that pertain to any particular stage of the Life Cycle will vary for each person. The ages we will define here are only meant to provide a guideline.

The first of the six stages designated by Modigliani is the period of Childhood. During this stage, money management is of minor importance since virtually all financial decisions are made by one's parents or other adults. However, even very small children can learn to "save", and begin to understand the principle of compound interest.

The second stage, Adolescence (ages 14 to 22), sees a person discovering a new personal world. For the first time we see ourselves as being apart from our original families. The financial issues related to this stage include learning to handle and care for money (owning a wallet), finding a first job, buying an automobile and saving for a particular larger goal, such as college.

Adulthood (ages 23 to 35), finds us nurturing a family and making a living. We become focused on perfecting our skills rather than on seeking new directions. Financially we strive to build our wealth through tax advantage (saving through qualified plans) and leverage (buying our first home).

In the fourth stage, Midlife (ages 36 to 50), we seek to discover our unique inner selves. Our financial strategy is to produce high rates of return and cash flow on our assets, while keeping expenses as low as possible. Often, the desire for liquidity and flexibility in our assets will conflict with the idea of long-term appreciation. We begin estate planning during this stage, analyzing what we have accomplished in the prior stages and how we want to channel those in the future.

When we reach the Maturity stage (ages 51 to 65), we begin to protect the use of our time and prune unimportant activities. In fact, our time is spent more on people rather than things. With our maximum consumption years coming to an end, we direct our financial strategies toward long-term retirement. We use our cumulative experience and knowledge as our main leverage for financial success at this time.

The sixth and final stage, Age and Simplicity (ages 66 and onward), finds us, as the name implies, recognizing the importance of simplicity in all aspects of our lives. At last, saving and long-term investment lose their need and we spend money as it is received. We keep living expenses low, although we may increase spending in the areas of estate planning and money management.

Modigliani's model of the Life Cycle was built upon the premise that most of us want to have a fairly stable level of consumption. In other words, if our income is low this year, but expected to be high next year, we don't want to scrimp on expenses now, only to be able to afford a much higher spending level next year. The answer, of course, is obvious: in high-income years we must save so that we can spend (dissave) in low-income years.

This simple, but eloquent, model can then be applied to our entire lifespan. Because income generally begins low for young adults, increases in the middle years and declines on retirement, young people borrow in order to spend more than their incomes, middle-aged people save a lot, and older people run down their savings.

When you add an understanding of the "Life Cycle" to your financial planning tool-kit, you increase your knowledge about the financial choices you must make, and when you must make them. In this way, you gain ever more control of your journey to financial freedom.