How much should a person save for his retirement? In 1976, Milton Friedman was awarded the Nobel Prize in economic science and one of his contributions was his theory that permanent income and not year-to-year income is the determining factor when assessing total consumption outlay. The present value of one’s future labor income is called human capital. Permanent income then is the constant level of consumption spending that has a present value equal to one’s human capital.

By understanding this model, one can consider possible approaches in computing how much to save for retirement. The first is to aim for a target replacement rate of preretirement income. This involves computing the amount you need to have accumulated in your personal retirement account when you reach retirement age. Then compute the annual amount of savings needed to reach that future value. The problem with this approach is it does not lead to your having the same consumption level after retirement as you did during your working years.

Here is where Friedman’s model comes into play. It is possible, in theory, to save as much so that one can spend the same amount on consumption before and after retiring. By computing for permanent income, one’s quality of life is preserved. Once a person can compute the present value of one’s lifetime resources, compute the annual constant level of consumption spending up to the expected life span.

All of these are simplification that gets muddled up when we consider inflation and the volatility of interest rates over time, especially over one’s lifetime. Likewise, the model should include initial wealth (representing inheritance) and desired bequests (for the next generation). Just the same, it is a framework that should guide any individual with a long-term view of life.

Complementing this is a life cycle hypothesis of household savings pioneered by Franco Modigliani, Nobel Prize winner in 1985. The simple model shows young people spending more than their incomes as they borrow for investment in education or their houses. The middle age is the time to accumulate money for retirement. And in the old age, one eats into savings as spending is generally higher than earnings. Assets can also be disposed of to support old age requirements and as one downsizes.

In a recent article by The Economist, the baby boomers — those born between 1946 and 1964 — have been cited as today’s generation that are either retired or retiring. Surveys show that this generation appears to own 52% of the net wealth in the US, even as they comprise 20% of the population. Not all are rich, but in the aggregate, they have amassed wealth. Because of medical and scientific advances, many remain strong and healthy. They are a big economic group with substantive purchasing power.

The Economist reports that the boomers are generally endowed and have saved enough, at least in developed countries like the US, Italy, Japan, England, Australia and Canada. For this reason, economists following the “life cycle theory” expect the boomers to shift from accumulating wealth to spending it. But the evidence says otherwise. Academics point to the “wealth decumulation puzzle,” where oldies spend less than what the theory predicts.

The data show retired households saving more today than in past years. The savings rate of people over 65 are in fact rising in the US, Canada, South Korea, Britain and Australia. Boomers are observed to be more miserly; hoarders, not bent on splurges.

Perhaps, improving health allows boomers to delay retirement and accumulate more wealth. The Economist, however, cites three phenomena affecting the observed puzzle: “bequest motives,” the pandemic and worries about care.

While boomers feel lucky about their fortune, they fear for the next generation who face more economic struggles. The response is they aim to leave more to pass on to their children as inheritance. The pandemic changed spending patterns and while the world has largely recovered, boomers are still spending less. With longer life expectations, the confidence that the savings will be enough with age is lower, especially with challenges of possible healthcare needs. This is called longevity risk or the risk of outliving your savings.

These studies are in developed countries with well-established pension and social security plans. In the Philippines, one wonders if the boomers have enough retirement savings at all. How much is the SSS benefit? Maintaining a comfortable lifestyle will likely be difficult for the many who have not planned for this life stage. Healthcare can be very expensive without health insurance.

With the higher likelihood that Filipino boomers have less savings than their developed country counterparts, the “bequest motive” and longevity risk add more pressure. Thus, the next generation must beware. Calculating one’s permanent income, no matter how rough, needs to be an exercise for all. Life spans are now generally longer, and young people must start early in thinking about their savings and retirement preparation.

The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as FINEX.


Benel Dela Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines.  He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs.