”Rules of Thumb” for Lifetime Savings

As long as people save on a regular basis and, importantly, stick to the saving ”rules of thumb” that they set for themselves, most will do well enough. People only suffer from using rules of thumb rather than more complicated calculations if they are very risk-averse, strongly disliking even small changes in how much they are able to consume.

These are the findings of research by Joachim Winter and colleagues, published in the May 2012 issue of the Economic Journal.

The researchers note that people”s ideal consumption and saving decisions require them to make very complicated calculations. In particular, people have to form correct expectations about their future income for the rest of their lives and anticipate how they will react to any shocks to their income. In reality, few people make these calculations and most instead use rules of thumb to determine their consumption and saving.

The researchers show that while people might be considerably better off if they made optimal decisions instead of following rules of thumb, the size of their losses depends on three things – their income profile, how uncertain their income is and their preferences. For most scenarios that they consider, losses remain below 10%.

They measure losses as the percentage increase in consumption in each period that would compensate a person for using a rule of thumb rather than making optimal decisions. When there is no uncertainty about income, losses are very low, mostly less than 1% compared with the total benefit the consumers could optimally attain. Even when income is uncertain, losses are below 10% for most scenarios.

The researchers analyse three simple rules of thumb. The first one goes back to John Maynard Keynes (1936) and implies that people simply spend all their income immediately, that is, they do not save at all.

The second rule was proposed by Milton Friedman (1957) and suggests that people always consume their ”permanent income”, that is, the level of consumption they could sustain over the rest of their life given their lifetime income.

The third rule was suggested by Angus Deaton (1992) and says that people always want to consume their expected income. They thus save if their income is unexpectedly high and draw on their savings if their income is unexpectedly low.

There is no rule of thumb that performs best in all scenarios. Rather, which rule performs best depends on how well each captures the savings behaviour that is required for a specific income process.

The three rules differ in the savings motives that they reflect. The Keynes rule does not incorporate any saving, while the Friedman rule tries to smooth consumption over the whole life. In contrast, the Deaton rule focuses on smoothing short-term income shocks.

Hence, if current shocks to income affect income only for a short period of time, the Deaton rule performs best. If, however, shocks to income alter the income path over a long period of time, then the Friedman rule performs better since it is aimed at smoothing these long-run shocks.

 ”Rules of Thumb in Life-cycle Saving Decisions” by Joachim Winter, Kathrin Schlafmann and Ralf Rodepeter is published in the May 2012 issue of the Economic Journal.

Further reading on the three rules of thumb:

Angus Deaton (1992) ”Household Saving in LDCs: Credit Markets, Insurance and Welfare”, Scandinavian Journal of Economics 94: 253-73

Milton Friedman (1957) A Theory of the Consumption Function, Princeton University Press

John Maynard Keynes (1936) The General Theory of Employment, Interest and Money, Macmillan

Joachim Winter

+49 89 2180 2459 | winter@lmu.de