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Life Cycle Theories of Savings and Consumption

Implications For Income Adequacy

In considering the economic status of current and future older persons, few would argue that money income alone is the best measure. Another approach is to use household net worth as a measure of economic status. Net worth is defined as the total market value of all assets, such as home equity, stocks and bonds, and savings accounts, minus all debts, such as mortgages, school loans, and automobile loans. Net worth is a conceptually important measure because it reflects the ability to have met consumption needs in the past (net worth will be positive if income has been higher than expenditures up to that point in one's life), as well as the capacity to finance future consumption by drawing upon accumulated assets.

Michael Hurd (1990) provides an overview of the different ways in which researchers have used current income and net worth to measure economic status. A widely used approach is to convert net worth into an income stream (based on life expectancy and interest rate assumptions) and add this income stream to current income, excluding the income already being received from assets. Such studies consistently show that the income stream generated from assets is modest for most elderly persons, especially those who have low incomes to begin with. Consequently, annuitizing assets has limited promise as a mechanism for increasing the incomes of elderly persons with inadequate incomes.

If the life-cycle hypothesis is correct, one would expect older adults (at least at the beginning of retirement) to have higher wealth holdings than younger households. Consistent with this expectation, Edward Wolff (1998) found that mean household net worth was $173,700 for households of those under age sixty-five and $314,500 for households headed by those age sixty-five and older. Growing recognition of the greater wealth of older households relative to younger households has led to increased interest in the potential role of asset holdings for meeting public policy objectives. An important example of this interest is the concern that elderly households with low money incomes but large amounts of home equity may be receiving income transfers through government programs from younger households that have higher money incomes but who would not be as well-off as older households if one took account of wealth.

Studies have repeatedly found that, except for the most affluent of older households, the majority of net worth is held in the form of home equity. Eller (1994) found that, in 1991, the median net worth of older households was $88,192, but was only $26,442 with home equity excluded. Recent evidence indicates that the effects of annuitizing household wealth are fairly similar across age groups, and that such a policy would have almost no effect on reducing household income inequality.

Although converting assets into an income stream is appealing—because it enables current income and wealth to be combined into a single measure—there are some problems with using it to compare households in different age cohorts. First, there is the problem of choosing an appropriate interest or discount rate for valuing the income stream produced by an asset. The discount rate can greatly influence the size of the income stream generated by an asset. In addition to the choice of an appropriate discount rate, there is the problem of changes in the size of income streams produced by assets at different stages in the life cycle. For a given amount of wealth, income streams will be larger for those with shorter life expectancies, making older households appear to be more affluent than younger households with the same amount of income and wealth. In addition, comparisons between older and younger households based on the income value of their assets will be influenced by the generally higher stock of durable goods held by older households.

Additional topics

Medicine EncyclopediaAging Healthy - Part 3Life Cycle Theories of Savings and Consumption - Implications For Retirement Behavior, Implications For Income Adequacy, Implications For Aggregate Savings And Consumption Patterns