Back in 1985, Franco Modigliani won the Nobel Prize for Economics by observing (from his perch at MIT) the

English: Photograph of Franco Modigliani taken...

English: Photograph of Franco Modigliani taken during the Ford/MIT Nobel Laureate Lecture Series on September 18, 2000 in Kresge Auditorium at the Massachusetts Institute of Technology, Cambridge, Massachusetts, USA. (Photo credit: Wikipedia)

simple technique that squirrels know intuitively from birth. You have to squirrel away some nuts during times of plenty so you can survive during times of scarcity.

In doing so, Prof. Modigliani looked at the income and expenses of typical people over the life span. He found that (typically) household income was more than sufficient to meet expenses during some times in the individual’s or family‘s life, while at other times money was tight.

So, it stood to reason (and still stands) that preparation during these times of surplus help families avoid going into debt during the cycle when they must increase their spending.
The good professor separated the life cycle into four distinct phases:

1. Before having children there is often a surplus of income.
2.While raising and educating children, there is often a deficit when the family is spending more than they are earning.
3. When children go out on their own, families often have a surplus again.
4. In retirement, the surplus is small if it is there at all.

So, conclusion follows: Saving during the two surplus periods of life is crucial to financial well-being later in life. Before the children arrive, squirrel away some money. And when the children leave home, you typically get one last chance to save for retirement or family legacy.

There are a bunch of financial “life lessons” to be gleaned from this research, and in our opinion, it can relieve people to understand where they are in the context of their life cycles, even if it doesn’t go exactly according to the above breakdown, in your family’s particular case.

We’ll start with a few lessons this blog, and will add some more next time.

1) When you are starting out, don’t try to duplicate your parents’ lifestyle.
Most of today’s college graduates are ill-prepared for the real world of financial responsibility. They never saw how their parents lived when they were first married and struggling. As a result, they can base their after-school expectations on an upper-middle-class lifestyle. Our suggestion for parents? Repeatedly emphasize, and show, that success is earned from the bottom up.

So, for example, if you are a young adult, you can’t afford more house than your budget will allow. If you spend 50% of your lifestyle expenses on housing, you will not be able to live proportionally on the rest of your income. Too much house is one of the most common mistakes young people make.

It is almost as though we can’t feel successful without immediately enjoying the lifestyle of our parents at the height of their careers! So, help your children decide how much house is enough, and help them to calculate what they can buy for 30% of their standard of living.

2) Encourage your children to save as much money as they can in their 20’s.
Early in your career, when the cost of basic needs is small, income often easily covers expenses, allowing the surplus to be used for savings, investment or added consumption.

saving and spending

saving and spending (Photo credit: 401(K) 2012)

Many young people assume they are doing so well financially that they can simply spend their extra money on more stuff. They don’t realize that these years of plenty won’t last.

During this period, save and invest up to 50% of your disposable income for future expenses. Fully fund Roth accounts, and fund 401(k) plans to take advantage of any employer match. Save 10% of your take-home pay for future large expenses. Put an additional 5 to 10% into what we call a Private Reserve Strategy where you can become your own banker instead of being a client of a banker.

This advice is especially important for those who delay marriage until they are in their 30s. Don’t waste a decade of prime saving and investing. You owe it to yourself and your future family to store up those nuts now.
If you want to know more about the Private Reserve Strategy, give us a call. We are personally dedicated to the success of your family — and to ALL of your finances. Can other tax professionals say that?
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