The Life-Cycle Hypothesis, Consumption Smoothing And Saving For Retirement : Planet Money : NPR

Rose Hansen

SYLVIE DOUGLIS, BYLINE: This is PLANET MONEY from NPR. (SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU’S “LOST SITUATION”) CARDIFF GARCIA, HOST: Hey, everyone. Welcome back to PLANET MONEY Summer School. (SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU’S “LOST SITUATION”) GARCIA: Today’s Class No. 3 – smooth spending and the 401(k). […]



SYLVIE DOUGLIS, BYLINE: This is PLANET MONEY from NPR.

(SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU’S “LOST SITUATION”)

CARDIFF GARCIA, HOST:

Hey, everyone. Welcome back to PLANET MONEY Summer School.

(SOUNDBITE OF BRICE MONTESSUIT AND CHARLES CASTE-BALLEREAU’S “LOST SITUATION”)

GARCIA: Today’s Class No. 3 – smooth spending and the 401(k). I’m Cardiff Garcia. And in the first two summer school classes, we looked at the stock market and how to pick stocks. And we will get to other markets in the next episode. But today we are learning and investing lesson that should matter to everyone, including people who, right now, are left out of the stock market.

Now, as we’ve said throughout Summer School, investing is about turning money now into more money in the future. But investing is also about making sure that you have the money you need when you need it. Would you have enough money to fix your car if it broke down tomorrow or in a year? How are you planning to pay for your kids’ college? Do you have a lot of debt to pay off? How old do you want to be when you retire? And do you want to leave money behind for your kids to inherit?

In this class, we are going to talk about investing strategies for planning across your whole lifetime and the challenges you’re likely to face in doing that. So for this class, I am joined once again by our PLANET MONEY Summer School professors – Allison Schrager of the Manhattan Institute…

ALLISON SCHRAGER: Hey.

GARCIA: …And Mihir Desai of Harvard Business School.

MIHIR DESAI: Great to be back.

GARCIA: So in our first Summer School class, we said that investing was about sending money into the future, that we invest our money now and take that risk with our money now with the hope that the risk will pay off, and we’ll have more money later in our lives. But there’s a lot more ways of investing besides just buying financial products like stocks or bonds, right?

SCHRAGER: Yes. I mean, another way to think about it is, if you take out a loan to go to college, that is increasing your earnings in the future. So that’s another way of bringing money into the future.

GARCIA: Yeah. And I bring this up, Mihir, because when people think about investing, they might think it’s all stocks and bonds and things like that. But there are other kinds of investing. And investing also is just very personal. How somebody should invest is very specific to that person’s circumstances.

DESAI: And in fact, one of the most important investments one can make is housing. And it’s quite confusing because you are both investing in something – a house that you may live in for a long time – but you’re also consuming. And it says a lot about who you are and the kind of life you’re going to live. So that’s an example of an investment decision that’s really hard because you’re not just investing. You’re also defining your life. How long is your commute going to be? Who are your neighbors going to be? What kind of schools might your kids go to? And that’s the sense in which investing runs through everything.

GARCIA: And the risks, Allison, also vary across all of these different possible investments as well, right?

SCHRAGER: Exactly. I mean, even if – to go back to the student debt example, say if you get a degree in engineering, you know, that’s probably less risky than film studies.

GARCIA: That’s right.

(SOUNDBITE OF MUSIC)

GARCIA: And the wisdom of the investment choices you make can also depend on where you are in life – your career path, how much money you can expect to make in your job, if you’re raising kids or you have to care for an elderly relative or how old you are. And there’s a concept that’s crucial to know if you want to take a smart approach to investing throughout your life. It’s explained in a PLANET MONEY episode from 2013, hosted by Marianne McCune and Alex Blumberg. This episode is about a group of people who were shut out of the financial system and then found brilliantly clever ways around it. So an excerpt from that story begins right after the break.

(SOUNDBITE OF MUSIC)

GARCIA: The U.S. Financial Diaries was a project that tracked the money habits of more than 200 low- and middle-income American households over the course of a year. And it included case studies of people who learned all these creative ways to borrow and lend money and to save money outside the formal banking system. That project also inspired this 2013 episode of PLANET MONEY from Marianne McCune and Alex Blumberg about some of these do-it-yourself approaches to managing money.

(SOUNDBITE OF ARCHIVED NPR BROADCAST)

ALEX BLUMBERG: Let’s start our exploration of these DIY financial systems with a guy you met last week.

MARIANNE MCCUNE: Yeah. I went up to talk to this guy in West Harlem. His name is Miguelo Rada – big guy, very friendly, in his 50s. If you’re in the neighborhood and you need a little cash, maybe you want to pay him a visit.

MIGUELO RADA: One time a guy came to me and he said, look. I’ve got to do something over the weekend. And he said, I need $20.

MCCUNE: Now, Miguelo isn’t the kind of guy you’d necessarily expect to have extra cash to lend. He just spent 32 years in prison. He got out last year. He’s living in a halfway house in West Harlem, and he’s on public assistance. But he’s gotten really good at penny-pinching these last six months. He even took a five-week course on financial management from a local credit union, the Neighborhood Trust.

BLUMBERG: And this guy who wanted the $20 was in the halfway house with Miguelo. He’s a musician, and he needed the money to get to a gig. He said he’d pay Miguelo the money back after he got paid over the weekend.

RADA: Monday morning, he came to me and he says, here, thank you very much. I appreciate it. I needed it. I said, no problem, man.

MCCUNE: Miguelo does this all the time. He’s lending out money in tiny amounts for short periods – maybe $20 or $30, not worth the trouble for a bank. But in a key way, he’s solving the same problem that the entire financial system is designed to solve.

BLUMBERG: Economists call it consumption smoothing. The times we get money don’t always line up with the times that we need money. So sometimes we save money ourselves and dip into that savings when we need it, and sometimes we borrow from other people who’ve saved money.

MCCUNE: If you have a bank or a credit card, this kind of thing is sort of invisible. If you don’t, you actually have to find someone who can fill that role. The people you’re lending to – could they borrow from a credit card or a bank?

RADA: Some of their credit is so bad, you know, it would be virtually impossible.

MCCUNE: So Miguelo basically runs this tiny bank out of his pocket. He and I were joking about it, and we went down a checklist of what banks do. Does he charge interest? No, he does not. Credit check?

RADA: (Laughter) I might ask somebody – what happened, man? Is there a way out? How did you get into this problem? And they go through all their stories, right? And then I look at that, and yes, I make an evaluation. But what I say is, all right, here.

MCCUNE: Record keeping.

RADA: It’s not that much, so I keep it up here in my head.

MCCUNE: You don’t have a ledger or, like, a note to yourself?

RADA: No, I don’t. No notes. Matter of fact, I rely on their honesty.

MCCUNE: OK. Last one, credit feedback.

RADA: If you don’t pay, it won’t happen again. That’s all.

MCCUNE: So he’s not being a bank as a business. But he took this class, and he got really into trying to help people manage their money and learn how to use credit. And then there’s a more surprising bankish (ph) thing that Miguelo does. He actually accepts deposits, like, from his much less frugal brother.

RADA: And I say, yo, you want me to hold something for you? And he was like, yeah, man. Hold this $100 for me. So I held his $100.

BLUMBERG: Like a bank, Miguelo takes deposits. But unlike a bank, when the depositor comes back to get his money out, Miguelo doesn’t just give it to him. He asks them a bunch of tough questions first, like, what are you going to use the money for? You’re not going to use it for something stupid, right? You’re not going to get yourself into trouble here.

MCCUNE: Right, like the last time his brother asked for his deposit back.

RADA: There was a look in his eye (laughter). Maybe I just projected that. But I asked him, what’s going on?

MCCUNE: Miguelo’s brother said he had to pay a bill. And even then, Miguelo wanted to see proof. He said, I’m coming with you.

RADA: He didn’t want me to go with him at first, but I convinced him. And I said, well, you’re not getting it. He said, you serious? I said, yeah, and I turned, and I started walking. He was like, yo, come here, man. And then I went with him and got his receipts for everything. I said, OK, everything’s cool.

BLUMBERG: I love to imagine, like, going to the ATM and your ATM hassling you about what you’re going to do with the money you’re withdrawing. You know, like, you’ve been going out a lot lately. Perhaps you should pack a lunch.

MCCUNE: Right. Do you need this money, or do you just want it? So this is another thing that distinguishes the formal financial system from the informal systems, like Miguelo’s. Miguelo is part banker, part social worker.

BLUMBERG: And there’s actually a social aspect to a lot of these informal financial systems. And the social aspect is actually a big reason that people use them.

MCCUNE: Right. So not too far from Miguelo’s halfway house in West Harlem is this funeral home. And I went there to talk to this young funeral director, Tamara Bullock, because she’s part of this thing called a sou-sou. It’s an informal savings club.

TAMARA BULLOCK: The bank thing is, like, totally new to me, but the sou-sou has been around forever. Like, I remember being a child and hearing my mom was in a sou-sou.

BLUMBERG: Sou-sous actually go by a lot of names, but the way it works is always pretty much the same. A group of people get together, and they say, OK. Every week, we’re all going to contribute a set amount of money each week. And each week, one member of the group is going to get the whole pot.

MCCUNE: Right. So the last sou-sou Tamara was in, she had 13 people in her group, mostly colleagues from her funeral home. And every two weeks – every payday, in their case – each of them put in $100. Tamara drew No. 7 from a hat, and that means that seven paydays in, she got her $1,300.

BLUMBERG: And people spend this money however they want. Some people use it to go on a shopping spree. Some people use it to travel. One woman in Tamara’s group is planning on using the money she gets to cover her moving expenses. Tamara used her last $1,300 for sort of a boring, but necessary, reason; she had to pay off a bill she’d gotten from a collection agency, and she used part of it for her rent.

MCCUNE: So the thing that’s odd about this is, the financial system has already set up a bunch of different ways for people to save money that give you, actually, a better deal than the sou-sou. They pay you interest, like a savings account.

BLUMBERG: And Tamara actually has a savings account. But she also has a sou-sou because the sou-sou offers advantages that a savings account doesn’t. One advantage – peer pressure. Now, your savings account – it won’t get mad at you if you don’t pay into it one week. But with a sou-sou…

BULLOCK: You have to. Like, there’s no ifs, ands or buts because other people are depending on you to be accountable. So you definitely have that in your mind that you have to do that.

MCCUNE: If someone does stop depositing, which is totally not allowed at all, the person who organized the sou-sou has to pay their share. And if people are late…

BULLOCK: Twice there was one person who was in the sou-sou who’s lost his job. He’s been late by, like, a day. So the next go-round, it’s already decided that he’s not going to be able to be in the sou-sou.

BLUMBERG: Can I just say, harsh informal system?

(LAUGHTER)

BLUMBERG: That is, like, way colder than the formal system. If you’re late by one day after you’ve lost your job, you’re out? Your credit card company is way more forgiving than that.

MCCUNE: And another advantage of the sou-sou for someone like Tamara, who says she loves shopping a little too much…

BULLOCK: I like that I can’t access it.

BLUMBERG: Just like with Miguelo hassling his brother about where his money is going, the sou-sou also uses this social pressure to keep your behavior in check. You say you want to save? We’re going to make sure you save.

MCCUNE: And the funeral director in the office next door to Tamara, Patricia Hamilton, who’s 62 years old – she says there’s another advantage to saving this way. It’s sort of the flip side to the social pressure. It’s the fun – the fun of doing this all in a group. Your ATM card – it does not get excited with what you’re going to do with the money you’re saving. But in a sou-sou, you dream and debate.

PATRICIA HAMILTON: But I think this time we’re going to go skydiving in the Rockies or Yellowstone National Park, something like that, or maybe in Puerto Rico.

BULLOCK: No. She thinks I’m skydiving again.

HAMILTON: She’s going to skydive again. We’re going to go swimming with the sharks, also.

BULLOCK: I’m not skydiving again.

HAMILTON: She’s going to skydive again.

BULLOCK: I’m not skydiving again.

BLUMBERG: So man, we, too, have been debating what we should think about all this stuff, all these DIY financial systems that people have set up. There can be problems with these sort of systems of informal credit. So no matter how good Miguelo’s friends are about paying him back, no matter how promptly Tamara pays into her sou-sou, no matter how much cash Mike Smith has stuffed in coffee cans in his house, none of that counts on their formal credit histories. None of that will help them get a loan to buy a house or a car or start a business or get a credit card.

MCCUNE: There is a credit union out in California that’s trying to record these kinds of social loans for people so that they do count toward their credit rating. But it’s going to be hard to capture a loan like the $20 that Miguelo gives to his friends.

BLUMBERG: And another problem – yeah, these informal lending networks – sure, sometimes it’s friends and relatives giving you a no-interest loan, like what Miguelo does. But Marianne, you talked to one expert who said that sometimes these friends that people borrow from – they’re not actually friends.

MCCUNE: Yeah. Jonathan Rollins, a financial adviser at the same place that Miguelo took that financial planning class – he said he’ll ask his clients, who’s the friend who gave you the loan? And they’ll say, well, it’s a friend of a friend. And actually, I owe quite a bit of interest.

JONATHAN ROLLINS: If someone says, yeah, I owe $1,000, but I’m paying $30 in interest a week, I know that it’s a 3% weekly loan shark loan. They’ll pay interest only until they can pay off the principal. It’s a tough debt cycle.

BLUMBERG: But the formal financial system can be dangerous as well. So remember, back at the beginning, we mentioned that project, the U.S. Financial Diaries. And another family that they profiled as part of their research is this family called the Johnsons, two working adults with three kids. And the Johnsons actually made a pretty good living. They averaged about $70,000 a year, six or seven times what Mike Smith, the guy with the lizard, was making. But in contrast to Mike, for the Johnsons, the monthly math just never worked out. They consistently, on average, spent more than they brought in each month.

MCCUNE: But because they had access to the credit system – to credit cards, home equity loans and lines of credit – they didn’t actually realize that. They had full-time and part-time jobs, and their income varied quite a bit month-to-month, as did their expenses. And so they just never became aware that they were steadily adding to their mountain of debt each month.

BLUMBERG: And this is one of the dark sides of the formal system. It’s too good at consumption smoothing, so good that it lets people believe they can consume more than they can actually afford to.

(SOUNDBITE OF MUSIC)

BLUMBERG: I’m Alex Blumberg.

MCCUNE: I’m Marianne McCune. Thanks for listening.

(SOUNDBITE OF MUSIC)

GARCIA: After a quick break, why consumption smoothing matters so much to the way you invest.

(SOUNDBITE OF MUSIC)

GARCIA: Cardiff back here again with our Summer School professors, Allison Schrager and Mihir Desai. I love this episode because it takes all these big ideas from economics and finance and banking about borrowing and saving, and it shows how they can work at this smaller, more intimate scale and in an informal setting.

SCHRAGER: You know, all my research as well has always found that people have this way of trying to consumption-smooth no matter what sort of banking they have access to. We also see a lot of these sorts of structures set up in developing countries as well. Because, you know, as humans, we’re programmed to, like, sort of store some nuts for the winter or borrow some nuts from someone else when we don’t have any. So it’s always amazing to me that with or without a formal financial sector, we always manage to find some way to do this.

GARCIA: Yeah. Let’s talk about how the concept of consumption smoothing, which was depicted in this episode in a very kind of short-term setting – so it gave the example of a musician who, before the weekend, borrowed some money so that he could keep spending throughout the weekend when he knew he was going to get a paying gig. And then on Monday, he turned right around and said, hey, I have the money now. I can pay you back. It’s a very short-term example of consumption smoothing. Let’s talk about examples of consumption smoothing that are relevant to how we think about investing, not just for the short term, but also for the long term.

SCHRAGER: So the most basic one is saving for retirement, right? So right now, you’re working, and you can consume out of your earnings. But someday, you will not have any earnings. So you have to save and invest now for the future. But I mean, so that’s the long-term consumption smoothing puzzle. But as we saw in that clip, there’s also the shorter-term one, which is, maybe you have really variable income, or maybe you’re a student now, so you’re not earning any income. So you have to borrow, maybe through your student loan, maybe through your family, to consume now because you know you’ll be earning more in the future.

DESAI: And it works in both ways, right? One is, you may need to save now so you can consume later. But it’s also about risk and uncertainty, which is, well, I don’t know if I’m going to have kids or if I’m not going to have kids. And I may need to save for that. I don’t know if I’m going to get sick at some point in the future, and I may not be able to work, and I may need to retire much earlier. So there’s the long-run picture, which is, gosh, you’ve got to save for retirement, or you may need to consume more than you currently earn when you’re young. But there’s also just that pervasive sense of, well, wait a second. There might end up being times in my life, situations that arise, that would actually require me to have savings.

GARCIA: Yeah. And on top of thinking through all this uncertainty and all these risks, it’s also just not easy psychologically to resist consuming now and spending the money we have now and saving money to invest it for the long term so that later in life you can pay off your debts and still have enough left over to save for emergencies and save for retirement.

DESAI: And in a way, this choice of how much consumption – the reason it’s so hard is, it’s supposed to reflect your lifetime income. Well, what the heck is that going to be?

(LAUGHTER)

DESAI: I mean, that’s a really hard thing to figure out.

SCHRAGER: Yeah. And we often discount the future. Like, we don’t put as much of a value on what happens in the future as what happens right now. Or you might underestimate risk. You might think, oh, this is a stable job. I’ll never lose it. And then you do. You know, there’s, as you point out, a lot of psychological factors that keep us from saving enough.

GARCIA: There is an idea in economics called the life cycle hypothesis that tries to explain how people use consumption smoothing throughout their lives, how they save and invest and spend money at different ages. So, Allison, take us through it, please.

SCHRAGER: So it starts when you’re born, and you’re building up human capital through education, and, you know, you might have to borrow against that, or maybe someone else is making an investment in you. And then you’re in your earning years. And this is sad to say, but most your pay increases happen in your 20s and 30s. And then you get to middle age, and that’s your sort of peak pay, and it stays like that for a while. And then you retire. And then you then have hopefully built up enough savings. You consume out of that in your retirement, and then you die.

(LAUGHTER)

GARCIA: So a lifetime in 30 seconds. Right. So I want to be clear about something. The life cycle hypothesis attempts to describe how people actually behave. And economists still debate to what extent people really do follow this pattern. My question is, should people follow it? Is it a good idea to approach investing with this theory in mind that when you’re young, you should feel OK about borrowing money, maybe to invest in your education or to buy a house; then, in middle age, you try to save money, maybe to invest in stocks and other things; and then, in old age, you spend down your investments and your savings.

SCHRAGER: Yeah, and I think people roughly do to the extent that they can. I mean, as we saw in that earlier clip, you know, they were all practicing some version of the life cycle hypothesis. You know, can you find, you know, various violations of it and, like, times, you know, in our lives we don’t make great financial decisions? Absolutely. Even I do this. But – and I’m a life cycle scholar. But, you know…

GARCIA: A life cyclist…

SCHRAGER: A life cyclist.

GARCIA: …One might say.

SCHRAGER: Yes. That’s…

GARCIA: The Lance Armstrong of life cycle theory.

(LAUGHTER)

DESAI: In a way, you know, if you think about your life generally, it’s bracketed by these two periods where you’re likely not making that much – when you’re very young and when you’re very old. And so the question is, how do you take that period in the middle and smooth it out?

GARCIA: Yeah. And real quick, I want to emphasize something else here. We are not encouraging people when they’re young to take out, like, an outrageous amount of student loans that they may never be able to pay back or to get a mortgage on a huge house that they’ll never be able to afford. But according to this life cycle approach to investing, some debt is not necessarily bad if you’re using it to make a smart investment that you expect to pay off later in life.

SCHRAGER: So when I teach students, they’re always shocked when I tell them that, you know, they’re poor, they’re in debt. And I was like, you’re actually sitting on a million-dollar asset. And that is roughly what your lifetime earnings are if you go to college. So you can’t access this money, but you are sitting on this asset and – ’cause you’ve made this investment in yourself. So the choices you make now are actually really important ’cause they put you on a path for the rest of your life.

(SOUNDBITE OF MUSIC)

GARCIA: OK. And next up, we are going to hear about the history of an idea that for a lot of people has made the life cycle approach to investing a reality, the 401(k), from the guy who invented it. That’s coming up right after a quick break.

It used to be that a lot of workers had a kind of pension plan known as a defined benefit plan, which meant that you would go work for a company, and then when you retired, that company would simply pay you a certain amount each year until you died. But in the 1970s, that started to change, partly because a new law incentivized companies to stop offering these kinds of pension plans, and partly because as people lived longer, these pensions became more expensive for companies to offer. And so a new kind of retirement plan was born, the 401(k). The excerpt you’re about to hear is from an episode of The Indicator from Planet Money that first aired in 2018. It was hosted by Stacey Vanek Smith, featuring her conversation with Ted Benna, the inventor of the 401(k).

(SOUNDBITE OF ARCHIVED NPR BROADCAST)

TED BENNA: Hello. My name’s Ted Benna, and I’m commonly referred to as the father of 401(k).

STACEY VANEK SMITH: In the late ’70s, Ted was working for a benefits consulting company, and he was trying to help a bank figure out some kind of retirement situation for its employees. And, you know, he was looking through the tax code, as you do, and he found this obscure little section, section 401(k). And this section allowed companies to create a retirement plan where workers could contribute a portion of their wages tax-free, and employers would also be allowed to match those contributions. And those matches would be tax deductible. Ted says when he saw this, he saw the potential right away.

BENNA: I guess the first thing that had me share (ph) was the fact that this is going to be huge. You know, this thing was going to catch fire.

VANEK SMITH: Ted says there were two reasons for this. First, it was something companies could offer workers, a real perk that could inspire loyalty. And it was relatively affordable, at least compared to the pension. Secondly, he felt like people would recognize right away that this could help them actually put aside money for retirement.

BENNA: Very few of us, including me, when we’re, you know, raising families and have all that responsibility, have the discipline to, every paycheck, you know, take a piece off the top and put it away and keep our sticky hands off of it. And so, you know, the biggest benefit from 401(k) for sure has been the fact that, you know, it makes that easier for people to do than if they had to do it on their own.

VANEK SMITH: Today, Americans have more than $5 trillion in 401(k) plans. Of course, not everyone thinks this is such a great thing. The 401(k) puts a lot of decisions into the hands of workers, and it can be really confusing to pick investments, and they’re often high fees associated with 401(k) services. Also, the fact you have to opt into a 401(k) plan means a lot of people just don’t. There has been talk about, you know, workers who are eligible just being automatically enrolled in a 401(k) unless they decide to opt out. But that hasn’t happened. And as of right now, most Americans have no retirement savings at all. Ted Benna says he finds this really upsetting, and he hates the fees associated with the 401(k). But all told, he says he is proud to be the father of the 401(k).

BENNA: I think (ph) it’s helped millions of Americans save somewhere between 10 and $15 trillion. Here, to make it more personal, I was in the supermarket just last week and bumped into a guy I hadn’t seen for years and said, hey, Carl, how you doing? He said, well, thanks to you, I’m retiring at the end of this year (laughter).

VANEK SMITH: (Laughter).

BENNA: And, you know, I’ve had that happen, you know, many times.

VANEK SMITH: And do you have a 401(k)?

BENNA: Sure, absolutely.

(SOUNDBITE OF OLIVIER RENOIR’S “EFFICIENTISSIMO”)

GARCIA: And Cardiff again here. And I’m joined once again by Allison Schrager and Mihir Desai. Mihir, what are the virtues of saving for retirement in a 401(k), as you see them?

DESAI: Well, there are many. So the first thing that’s amazing about the 401(k) is it solves this problem of you can move between employers and you can take your 401(k) with you. The second big thing is it solves this self-control problem because it comes out of your paycheck before you even see it, and you can’t access it that easily. And then the final thing that it solves is it actually provides a huge tax benefit. We actually give a big incentive to savings via these 401(k)s. Basically, your return is tax-free. So for all those reasons, the 401(k) can actually be a really powerful tool. The most important of one, the last one, which we haven’t really mentioned too much, is just sheer compounding because it happens over the course of your lifetime.

GARCIA: Yeah, compounding is a really important concept. And I got to say it’s a little tricky to explain, but the key point is that it’s not just the original amount of money that you invest in stocks or in bonds or whatever that generates returns each year. It’s also that those early returns then get reinvested and generate their own returns. And so the pile of money you have to invest just keeps getting bigger and bigger. And that’s also why it’s good to invest for a long time, to let that pile keep growing. My PLANET MONEY colleagues actually covered this recently in the Bobby Bonilla episode, but let’s just pause for a second to explain why it’s such a big deal.

DESAI: So the reason why it’s such a powerful idea is if you save for many, many years and then you don’t access it for 30 or 40 years, you can actually have your money double and triple if you earn the high rates of return – that if you are able to earn 7%, for example, every year over the course of 10 years, your money doubles. And if you do that over the course of 20 and 30 and 40 years, it really compounds. And so the beauty of the 401(k) and all these big savings vehicles is they really allow you to capitalize on compounding. And then if you can’t touch it because of these penalties, it’s even better.

GARCIA: And there are a couple of things that actually do seem a little bit potentially problematic about 401(k)s. One is simply that there is some inequality in who participates in them. I mean, fewer than half of workers invest through 401(k)s or other similar plans. And a lot of these workers just don’t have access to them. But the second thing is that 401(k)s do put the burden of making the investments on the workers themselves. And so therefore, the onus of understanding the available investments is also on the workers. This is unlike the earlier kinds of retirement plans where it was the company’s responsibility.

SCHRAGER: Well, it is and it isn’t a problem. In the last, say, 20 years, we’ve had more experience with 401(k)-type plans. And we’ve learned ways to put less of an onus on individuals, mainly through automatically signing up these people for these plans and automatically investing something – (unintelligible) them in a sensible investment strategy. Usually it’s something that puts you in stocks when you’re young and moves you more into bonds as you get older. So that part of the problem is actually more or less taken care of now. And the evidence on it is it’s worked phenomenally well.

But we still haven’t solved the whole problem. There’s a huge risk problem when people actually retire, which is, how much are they going to spend each year when they don’t know how long they’re going to live? And we actually haven’t come up with a very good solution for that yet.

DESAI: I think this problem of the burden on workers was hard. But it goes back to something we talked about the last episode, which is these passive index funds are a very cheap way – if you just put all your money in your retirement accounts into those things, you’ve solved the problem, and you don’t have to think too much. So the best thing you can do is choose the lowest-fee index product you have in your retirement choices. Put it in there. Don’t ever change it. Wake up in 30 years, and everything will be fine.

GARCIA: Is it ever too late to start saving for retirement?

SCHRAGER: No, never. I mean, maybe if you’re already retired.

(LAUGHTER)

GARCIA: Then there’s nothing to save, right?

SCHRAGER: Yeah. Or you don’t have any income coming in then, you know, maybe then. But no, I mean, you can start any time. And in fact, there’s a limit on how much you can put in your 401(k) each year. But once you get above 55, that limit increases. So we can encourage people to save even more as they get closer to retirement.

GARCIA: OK. And that bit of advice wraps things up for Class No. 3. Next up in our PLANET MONEY Summer School series – the bond market, including the story of a very risky bond that I once got for Christmas. True story. But before we let you go, keep in mind some vocab words that will be tested at the end of summer school on our final exam – first up, consumption smoothing, a way to spend roughly the same amount of money in a given period of time by borrowing money or spending your savings when you’re not making enough and saving money when you’re making more than you need; next, the life cycle hypothesis, the idea that people tend to borrow money when they’re young, save and invest in middle age, and then spend down their savings in old age; and finally, the 401(k), a retirement plan that revolutionized the way workers approach investing.

(SOUNDBITE OF ALEXANDER ACE BAKER AND CLAIR MARLO’S “SUN, SWEAT, SKIN”)

GARCIA: This is Season 2 of PLANET MONEY Summer School. If you want to catch up on Season 1, the easiest way is just to Google PLANET MONEY Summer School, and you’ll find a page where you can see all of last year’s episodes on how to think like an economist and even a final exam for when you’re done.

(SOUNDBITE OF ALEXANDER ACE BAKER AND CLAIR MARLO’S “SUN, SWEAT, SKIN”)

GARCIA: PLANET MONEY Summer School is produced by Audrey Dilling with help from Alexi Horowitz-Ghazi and Isaac Rodrigues. It is edited by Alex Goldmark. Our project manager is Devin Mellor, and special thanks to Liana Simstrom. You can find us on social media everywhere as @PlanetMoney, but we do read emails at [email protected] Just put summer school in the subject line, please. I’m Cardiff Garcia, and I’m also, by the way, the host of an upcoming podcast called “The New Bazaar” to which you can now subscribe at all the usual podcast places. First episode drops Thursday, August 12. PLANET MONEY is a production of NPR, and thanks for listening.

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