Most people need to save for retirement if they are to maintain their standard of living when they stop working. There has been a lot of research and discussion about how much people need to save and how that compares to the savings encouraged by automatic enrollment in occupational pension plans. However, there has been little discussion of when individuals should save for their retirement and the relevance of a single default contribution rate for all.
In this briefing note, we use a life cycle economic model to illustrate that there are good reasons why savings rates are not constant over the working life, due to predictable factors that change. with age. The model is a simple approximation of real life, as individuals face little uncertainty and can only save in an asset whose rate of return is known. People choose how much to spend each year and how much to save, with the aim of smoothing their standard of living over their lifecycle. Although it is necessarily simple to be processed by calculation, this model gives important conclusions with implications for the design of real world policies.
- Most people expect some income growth over the course of their working life. If an individual aims to smooth spending over their lifetime, then they should save a greater proportion of their income for retirement at older ages when incomes are higher, rather than saving at a constant rate throughout. throughout his working life.
- It is generally assumed that households with children need higher expenses to achieve the same standard of living than those without. Given this, most parents aiming to smooth out their standard of living over the course of their lifetime should save relatively more for retirement before their children arrive and / or after they leave home.
- Many young graduates hold student loans which will be amortized after a certain time (30 years after graduation for those entering higher education from 2012). Graduates who wish to smooth their standard of living over time should increase their retirement savings by the amount of their previous loan repayments when loans are canceled.
- Employer pension contributions that are only paid if the employee also contributes motivates individuals to contribute throughout working life, even in years when income is relatively low or there are children in the workforce. household (or if for some other reason living expenses are higher). However, individuals are likely to want to contribute only the minimum required to receive the employer’s contribution during the first half of working life. When incomes rise and / or children leave home, then they should significantly increase their retirement savings rate.
- This profile of the appropriate saving rate over the working life in the presence of conditional employer pension contributions – stable at the level of the minimum required employee contribution, then sharply increasing when children leave home – is robust to a series of plausible assumptions about the economy’s rate of return.
- Uncertainty about future income trends deters individuals from leaving all of their retirement savings to a short period at the end of their working life. In the face of uncertainty about income and employment, people should save more at a younger age, especially in high income years. However, the general trend remains – that is, many should save the minimum amount early in their working life and then significantly increase their savings rate when children leave home.