What Is the Life-Cycle Hypothesis (LCH)?
The life-cycle hypothesis (LCH) is an economic theory that describes the spending and saving habits of people over the course of a lifetime. The theory states that individuals seek to smooth consumption throughout their lifetime by borrowing when their income is low and saving when their income is high.
The concept was developed by economists Franco Modigliani and his student Richard Brumberg in the early 1950s.
- The Life-Cycle Hypothesis (LCH) is an economic theory developed in the early 1950s that posits that people plan their spending throughout their lifetimes, factoring in their future income.
- A graph of the LCH shows a hump-shaped pattern of wealth accumulation that is low during youth and old age and high in middle age.
- One implication is that younger people have a greater capacity to take investment risks than older individuals who need to draw down accumulated savings.
Understanding the Life-Cycle Hypothesis
The LCH assumes that individuals plan their spending over their lifetimes, taking into account their future income. Accordingly, they take on debt when they are young, assuming future income will enable them to pay it off. They then save during middle age in order to maintain their level of consumption when they retire.
A graph of an individual's spending over time thus shows a hump-shaped pattern in which wealth accumulation is low during youth and old age and high during middle age.
Life-Cycle Hypothesis vs. Keynesian Theory
The LCH replaced an earlier hypothesis developed by economist John Maynard Keynes in 1937. Keynes believed that savings were just another good and that the percentage that individuals allocated to their savings would grow as their incomes rose. This presented a potential problem in that it implied that as a nation’s incomes grew, a savings glut would result, and aggregate demand and economic output would stagnate.
Another problem with Keynes' theory is that he did not address people's consumption patterns over time. For example, an individual in middle age who is the head of a family will consume more than a retiree. Although subsequent research has generally supported the LCH, it also has its problems.
The LCH has largely supplanted Keynesian economic thinking about spending and savings patterns.
Special Considerations for the Life-Cycle Hypothesis
The LCH makes several assumptions. For example, the theory assumes that people deplete their wealth during old age. Often, however, the wealth is passed on to children, or older people may be unwilling to spend their wealth. The theory also assumes that people plan ahead when it comes to building wealth, but many procrastinate or lack the discipline to save.
Another assumption is that people earn the most when they are of working age. However, some people choose to work less when they are relatively young and to continue to work part-time when they reach retirement age.
As a result, one implication is that younger people are more able to take on investment risks than older individuals, which remains a widely accepted tenet of personal finance.
Other assumptions of note are that those with high incomes are more able to save and have greater financial savvy than those on low incomes. People with low incomes may have credit card debt and less disposable income. Lastly, safety nets or means-tested benefits for the elderly may discourage people from saving as they anticipate receiving a higher social security payment when they retire.