Three generations of you

In the third season of West World, a dystopian television series, there is an episode where William (the ‘man in black’) has a surrealistic therapy session with different versions of himself; from a young child to an old man. This got me thinking about the different stages in life that we go through and what would happen if we could have an open and honest discussion with three, or even more, generations of ourselves with an economist as a therapist.

Economists often talk about smoothing our consumption over our life-time. In the mind of an economist, our personal holistic balance sheet has two assets; future salaries (human capital) and financial wealth. The purpose of workplace pensions is to defer some part of our salary until we retire. This will help us smooth our consumption over our life time. To make pensions affordable we need to earn an investment return above inflation, by taking financial risk.

The usual pension discussion

In the discussion with our older self, the economist (our therapist) explains how we should invest our pension savings using life cycle theory as the base. The rule of thumb is to take a lot of financial risk in younger years and then reduce the financial risk as the value of our human capital (i.e. future salaries) slowly decreases.

In the therapy session, my older self tries to convince my current self that I should put away more money while working so that I can maintain a decent living standard in retirement. This is not an easy conversation since there are so many other needs in the present. The recent increase in cost of living has put many under financial pressure. When we have to choose between putting the heating on or ensuring there is enough food on the table, saving for our future self feels less urgent.

Your younger self

In the middle of my debate with myself, the therapist turns to my younger self and asks how I could help my older versions. The maths is simple, double your lifetime contributions and your pension income will double, everything else being equal. The economist explains that instead of saving a higher proportion of my income each month, I could improve the situation for my future self by leveraging my human capital. In other words, investing in myself so that I increase my chances of earning a higher salary in the future.

Getting a university degree is one way for my younger self to leverage the human capital. The cost of attending university is typically financed by student loans and grants. The alternative cost of getting a university degree is giving up the income that I could have earned while studying. Taking a student loan is to borrow from your future self and invest that in your human capital. It is likely that both your future selves, in the therapy session, will thank you. If you manage to double your future income, your future pension contributions will automatically double.

Student loans – a financially attractive form of leverage

Most think of leverage as something dangerous. We hear about speculators who made a fortune, or lost it all, by aggressively leveraging their investment portfolio. It could be risky with excessive leverage, since there is a risk that the cost of serving the debt could turn out to be larger than the anticipated gains.

In the UK, Netherlands and Sweden among others, student loans have an asymmetric pay-out profile. The annual repayments of student loans are based on your income and not the size of your loan. If your investment in education doesn’t pay-off in terms of a better future income, you are not forced to give up a big chunk of your future consumption. If it pays off, you are ‘only’ paying an education tax on your income until your loan has been paid back in full.

A positive form of ‘privatise profits and socialise losses’ at an individual level, but with a clear win on the societal level. This makes student loans more similar to an education tax than credit card debt.

Only for the young?

In the therapy session, my middle life self makes a surprising comment. With the increasing automation of many jobs, my human capital could depreciate as my current knowledge may no longer be in demand. My older self, looks uncomfortable while my younger self suggest that I might want to study, or learn new skills, to boost my human capital. Then my older self says something unexpected, that it would be nice to be able to work part-time beyond the official retirement age. It is not for the money, but for the social aspects.

The therapist says that it is a great idea. Today’s three stages of life; study, work and retire is a relic from the industrial revolution, instead we should think of life in multiple stages. Adding a midlife education period could result in; study, work, study, work, part-time work/retirement and full-time retirement. Perhaps a midlife education would be financed by a combination of financial capital (pension savings) and a midlife student loan.

Forgotten pension advices

Pensions and student loans are different sides of the same coin. First you borrow from your future midlife self, and then save for your future older self. A sort of intergenerational transfer with your midlife self at the centre. The first part of the transfer is something that we tend to forget as pension specialists as we focus on the financial wealth side of the individual’s balance sheet.

When talking to young people about pensions, we should not forget to mention that going to university and financing that with a student loan could turn out to be their best pension investment. When talking about pensions with someone in their midlife, we should not forget the importance of boosting the human capital by preparing for a second career that could last well into the 70s.