A financial life cycle is a term that financial professionals use to describe where we are in our life and how it affects our financial situation. It’s a way of measuring where we are and where we should be in the next few years. Many of us tend to lag behind in the financial life cycle, having the good habits that served us well in the previous stage of our financial life cycle, but not having suitable skills for the stage we are at present and barely planning for the next stage. If you know where you are in the financial life cycle, you can then judge where you fall short and which skills you can learn.
1. The Early Years
The first part of your financial life cycle is your childhood and early adult years. In these years, you are mainly studying, and the jobs that you can pick up tend to be part-time, unskilled, and poorly paid. They are more useful in teaching you what work is like rather than the spending money that they bring in. It is OK to be financially dependent on your parents; they don’t want you to drop out of education in order to get some quick money now. It is also okay to build up (some) long term debt, as your education should in the end pay for this several times over.
2. The First Jobs
You then have the period of early earning. This is the period of the first few jobs, when although the pay is lower than it will be later in the career, costs are so much less, as there are no spouses, children or homes to pay for. Salaries also rise rapidly. During this period, a large chunk of student debt can be paid off; it is also a period when a new career can be tried out with little being lost. Starting a pension and getting on the housing ladder may not be the most fashionable things at this age, but doing these things now will pay dividends later.
This period is also a time to start dabbling in investments, as money lost now can easily be replaced, and so high risk investments can be considered. A big win now could be worth an enormous amount later, while lost money can easily be replaced. All the time lessons, from both winning and losing investments, will be learned that will pay off later.
Many people don’t fully use this exciting period. For a start, they may put this period off by getting more and more college degrees with no idea of where they will be in the future. They may also still spend more than they earn, remaining dependent on their parents into their thirties or building up greater debt. More importantly, there is not much desire to learn about saving or investing at this age, missing out on the best time to start a pension.
This early stage continues on into the early stages of marriage. It is a period of relative affluence that should be enjoyed, but it is also a period where a good deal should be learned about investing and saving, as you will need those savings later.
3. The Young Family
Most people remember the early years of having a family as one where there never seemed to be any money. At this time, one of the spouses often stops work for a few years, or sharply cuts down their hours. The other spouse would see their pay rising slower than it had been previously, and there are sudden expenses. Children are never cheap.
In these times there needs to be a new frugality. Investment needs to be maintained, if for no other reason than to keep in the habit. Debt will seem to get larger, but it should be a different type of debt from student debt – being for a larger house. Purchases will also be more practical and less glamorous. The sports car is replaced by a station wagon, and the flat in the fashionable area of town is replaced by a house in the suburbs. There is also a need to start (or continue) saving for college funds.
There is a desire to retain the old lifestyle, which can mean that debts build up more easily. This is made possible by greater access to credit, as the house is now a substantial asset, and while the pay is not rising at the fast rate that it was, the pay raises have still compounded, and so the money that is being earned is more than ever before. Debt to fund a lifestyle is the biggest problem at this stage. Unfortunately, the lifestyle does take a hit when children come along. This is not easy when friends from school and colleagues at work are still enjoying exotic holidays and constant nights out.
4. A Growing Family
The next stage is when the children are growing up. The expenses start to seem less. The pay is still rising, and in fact many people are at the peak of their earning power, at least in real terms (the pay may still keep on rising after this, but for most people, inflation starts eating away at the pay rises). The spouse who may not have been working can now restart a full time job.
The temptation here is to keep the savings at the same rate as before. The idea here is not to maintain the savings and investments that were made when you were, to all intents and purposes, quite poor, but to expand them. Debts should no longer be treated in maintenance mode; this is no longer something that is excusable as it was when the children were very young. Credit card debts should be paid down quickly, and then the mortgage needs to be attacked and preferably paid off.
The mortgage in particular will be more manageable, as inflation will make the amount of the mortgage seem far lower. At the same time, there should be a step up in payments to the investments that were being maintained over the early years of family building.
5. The Empty Nest
After the family has left, there is an empty nest period. The children are out of college and earning a living, and even if they are at home, they are paying their own way. It is okay to enjoy yourself at this time, as the disposable income will rocket. However this is not a long time. One of the things that should be done is to start de-risking investments. Losing a bundle at this stage is going to have far more long term effects than it will at any of the earlier stages, as you will not have the time to make this money back. A cold, hard look at investment accounts should be made, and your investment portfolio should become far more boring. Also, debts should finally be paid off (if they have not been already). This will be fairly easy, but just because it’s easy, doesn’t mean it should be shunned.
One of the shocks at this time – particularly if you put retirement off for a while to continue working – is that wages can often start falling. This is not just the case for lifestyle reasons, as part-time working or a job close to home suddenly makes more sense, but for the very fact that employers want younger people who aren’t about to retire.
Finally, there are the pension years when you are living off past earnings. This is a time to live off your past good habits. The disposable income will start to drop off, and inflation can be bitter during this time (even if the pension is index linked). However. if you have saved up enough, these are likely to be golden years.
This is a period where people tend to hold on to things that they don’t need to. The main example is the large family house. It is a good idea to downsize and to live off the money. At a later stage, a reverse mortgage may be a good idea so that you can benefit from the equity in the house. Your children may not be ecstatic about the choice, but they have got a career and a home and should be in a saving habit. It is also time to put the investment portfolio into income generating assets; high-risk, fast-growth companies aren’t much use now.
Everyone will hit different stages of the financial life cycle at different ages. However, your investment and spending needs do change throughout your life, and if you are not consciously recognizing, you will be playing catch up, as you use the good habits that you obtained in the last stage of your financial life cycle, but are learning the habits that you need in the current stage only by your mistakes.