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This article proposes that people generally prefer present consumption to future consumption because their expected utility from consumption (eventually) falls as their mental and physical abilities (eventually) decline with age. Moreover, contrary to the ubiquitous intertemporal formulation with a constant rate of time preference and contrary to three recent theories of time preference that predict decreasing discounting as people age, this article asserts that discounting increases over the life cycle. This hypothesis is supported by data from the Panel Study of Income Dynamics as well as evidence from numerous previous studies. (JEL D91)
ABBREVIATIONS
AFS: Annual Food Standard
CES: Consumer Expenditure Survey
CPI: Consumer Price Index
PSID: Panel Study of Income Dynamics
I. INTRODUCTION
Despite the almost universal assumption of time preference in models of intertemporal choice, an adequate explanation of why people discount the future has not been provided.1 Olsen and Bailey (1981) make a convincing case for positive time preference by contradiction (i.e., without time preference models of intertemporal choice do not yield predictions consistent with observed behavior), but they do not explain why individuals would rationally discount the future.2 Three recent studies have attempted to provide the explanation. Rogers (1994) argues that societies that discount the future (at a rate of about 2%) will be the long-run survivors in an evolutionary fitness situation.3 Posner (1995) argues that discounting occurs because individuals have "multiple selves," that is, "people are weighting their present consumption far more heavily than their future consumption... [because] the present self and the future self are, in some meaningful sense, separate persons" (92). Becker and Mulligan (1997) argue that discounting occurs because of a rational "defective recognition of future utilities" (730). But, as will be shown, these three theories are inconsistent with empirical evidence on consumption over the life cycle in at least one important aspect.
The theory may also provide an explanation of why few people buy annuities. The traditional model suggests that annuities should be an attractive way to insure for longevity. Yet very few people buy annuities.45 The life-cycle felicity hypothesis provides a simple explanation. Consumption in old age is expected to yield low felicity. Thus, actuarially fair annuities are far from being fair in terms of felicity.
Perhaps the most important ramification of the...