Four Phases of the Family Financial Cycle

money jarBy David John Marotta

In 1985, an MIT professor won the Nobel Prize for a simple technique that squirrels have known intuitively from birth — you have to “squirrel” away some nuts during times of plenty so you can survive during times of scarcity. Economist Franco Modigliani won his Nobel Prize for modeling how humans manage their household finances over a lifetime.

Modigliani looked at the income and expenses of typical people over their life from the time they entered the workplace, raised their families, and retired. He found there were times when the household’s income was more than sufficient to meet their expenses and other times when money was tight. Preparation during these times of surplus help families avoid going into debt during times that require increased spending.

Before the children arrive, squirrel away some money. When the children go out on their own you get one last chance to save for retirement!

1. Pre-child surplus of income

2. Child raising & education income deficit

3. Post-child income surplus

4. Retirement small surplus

Two periods of this life cycle have surpluses. Saving during these periods is crucial to financial well being later in life.

Pre-child surplus of income: Early in your career, when the cost of basic needs is small, income often abundantly covers expenses allowing the surplus to be used for savings, investment or added consumption. Many young people make the mistake of assuming that they are doing so well financially that they can simply spend their extra money on added consumption. They do not realize that these years of plenty will be followed by years of famine.

During this period up to 50% of your disposable income should be saved and invested for future expenses. Roth accounts should be fully funded, and 401k plans should be funded to take advantage of any employer match. Ten percent of your take home pay should be saved for future large expenses and an additional five to ten percent put into long term taxable savings.

Child raising & education income deficit: Those of you have raised a family know how expenses multiply once children enter a family. The one bedroom apartment is replaced by a four-bedroom home with a mortgage. If expenses for food, clothing, medical, dental, clubs, camps and lessons aren’t enough, children have their own set of endless marginal desires! In total, the average cost of raising a child to age 18 in current dollars is about $350,000. After a third of a million dollars in payments, the balloon payment for children comes at the end when college expenses are often financed through student loans and additional mortgages. During these years many couples wish they had not spent their pre-child surplus!

Post-child income surplus: For most families expenses drop significantly after their children are through college and out on their own. Although starting younger is ideal, these are the years when many families realize that they only have several more years to prepare for their retirement and they seek professional financial advice. This period provides a second chance to save and provide for a financially secure retirement.

If you are in this stage of life and find yourself wondering if you are ever going to have enough for retirement, get professional advice. You need to know exactly how much you should be saving in order to achieve a comfortable retirement. There is still time, but you don’t have the luxury of guessing at the appropriate savings rate.

Retirement small surplus: Retirement hopefully finds the family with income adequate to continue their usual lifestyle. With sufficient assets and good asset management, income from savings and investments, pensions and benefits should cover their retirement expenses.

During retirement it is crucial to know what rate of withdrawal is safe. Spend too much and you will run out of money. Be too frugal and you needlessly put a damper on the years you might be traveling and gifting. It is also crucial to have the right asset allocation in order to provide enough growth for a long and prosperous retirement, but enough stability to weather market upheavals. This is another time that does not allow for guesswork

The lessons to learn from Modigliani’s work are simple: “Before the children arrive, squirrel away some money. When the children go out on their own you get one last chance to save for retirement!”

David John Marotta works at Marotta Asset Management, Inc. of Charlottesville which provides fee-only financial planning and asset management.

Image courtesy of ChrisCarpenter

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4 Responses to Four Phases of the Family Financial Cycle

  1. Traciatim says:

    Sure that works in a perfect world where people are all mindless robots and nothing happens outside of plans.

    I much prefer the David Chilton version of simply save 10% your whole life, and retire wealthy. (a little simplistic, but it works). At least this way you spend the excess any way you wish.

    There is also the David Bach version of the baskets for security, freedom, and dreams. This works pretty well too for real life since they can be used for the down times.

    I think the underlying message in all of the plans though is ‘Stop spending all of your money’. Personal finance and financial security all comes down to that one single point. If that one single point could be mastered by the general public I bet the world would be a much better less stressful place.

  2. Juan20 says:

    That is a great article. I never thought of the squirrel adage. It is so true though.

  3. a says:

    but traciatem’s comments are even more useful, thought-provoking.

  4. LC says:

    My DH and I are 27. We have saved enough for retirement already that even if we never save another penny we will have $1M at 50 (assuming only 8%). We will also have our mortgage paid off well before then. We are planning kids in a few years and we have already started saving for their college and we have a fund started for all the “startup costs.” It’s really not that hard if you start young. Good advice though.

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