A while back I published a post on my own experience with payment cycles. I had switched from being paid on a monthly basis (UK) to being paid on a fortnightly basis (AU), and I talked through its effects on my budgeting and financial decision-making. In that post I also mention that some, but relatively little, research has focused on the effect of payment cycle on financial decision-making. And this is true. Well, partially true. Whereas there’s little research looking at changes in predictable payment cycles, there’s a large and growing literature out there on the effect of unpredictable payment cycles on financial decision-making. In today’s post we’re diving into the effects of volatile income on spending, savings, lending, budgeting and other (financial) decisions.
Research by Peetz et al looked at the effect of income volatility on personal financial insecurity and personal financial planning. They conducted two studies and found that participants who reported more month-to-month variability in their actual income were less likely to have planned for financial contingencies (Study 1). They also found that lower internal locus of control partially mediated the link between volatility and financial planning decisions, and lower internal locus of economic control predicted financial planning decisions independently of volatility. The first study shows both a direct and mediated relationship, but was purely observational. As a complement, the second study was an experiment in which participants were randomly assigned to receive volatile (vs. stable) payments in a simulated work environment. The researchers found that those in volatile payment conditions were less likely to save their compensation for this work. Again, lower internal locus of economic control predicted financial planning decisions independently of volatility. This research demonstrates a causal link between income volatility and financial decisions, specifically a heightened tendency to make short-term financial decisions. However, we do have to keep in mind that both studies also underlined the importance of internal locus of control for financial planning decisions. In a similar vein, research by West et al, found that experiencing more income volatility (including a higher frequency of either income dips or spikes) is associated with greater financial impatience (the preference to receive a small sum of money immediately over a larger sum of money later). To show this they use a multi-method approach on longitudinal data on biannual income. In study 1 they show that this effect operates above and beyond individual differences in income risk preferences and wealth. Study 2 then replicates these correlational findings with recent month-to-month income volatility and finds that this effect occurs primarily among people who report having little control over their finances. Moving from correlational to causal, a longitudinal field experimental with low-income working women (study 3) randomly assigns participants to receive cash transfers amounting to a median monthly income spike of 29% (in the control condition participants receive no cash transfers). Those that receive the cash transfers exhibit significantly greater financial impatience compared to the control condition. The effects of income volatility can have effects beyond the domain of financial decision-making. Research by Prause et al tested whether absolute volatility or downward volatility in income predicted depression (controlling for prior depression). Their sample were 4,493 participants from the National Longitudinal Survey of Youth (NLSY79) with depression (CESD) measured at age 40 and prior depression measured eight to 10 years earlier. They found that downward volatility (frequency of income loss) was positively associated with depression; meaning that depression became increasingly likely amongst those who were unpredictably losing income. The second finding, however, is a bit more difficult to place in context: when adjusting for downward volatility and other covariates, absolute volatility (so unpredictable income gains included) was negatively associated with depression. So volatile income need not directly lead to depression, unless it’s clearly a loss in income. Continuing on the topic of health, research by Addo & Servon showed that income volatility also impacted medical decision-making. They studied a varied sample of Americans focusing on prime working age adults (aged 27 through 55), primarily female, highly educated (more than half had at least a BA/4-year college degree), racially diverse (70% non-white, 30% white), with a median income of $60,000. I’m giving you all those details to be able to put the sample into context. Of this sample, more than half depended on multiple income sources to make ends meet. Very interestingly, from a behavioural economist’s perspective, most were familiar with fintech (such as banking, budgeting, and credit monitoring apps) but did not see this as a solution to fundamental financial challenges they faced, which is what most of these tools have been designed for. Surprisingly, the majority of the study population had health insurance, and more than three quarters had employer sponsored plans (I say surprisingly because it’s an American sample, bear with me). But health insurance was not enough to make health care affordable, beyond primary care or preventive services. And this is where we get to the crux of the problem: due to income volatility, health insurance was a source of uncertainty in health care decision-making. Some participants opted to skip or delay care due to cost, or when they couldn’t anticipate the cost of treatment as well as couldn’t figure out their income for that period. And there we have it: with unpredictable income it’s almost impossible to be able to figure out whether you can afford big ticket items. And one of those items is, in quite a few countries, healthcare.
I’ve outlined several effects of income volatility on (financial) decision-making. But before I did this, I should’ve maybe mentioned to whom this matters. Throughout the article you might have been asking yourself, “who is affected most by volatile income?” And not a soul should be surprised that the largest proportion of those with volatile incomes can be found to be part of the gig-economy, which is disproportionality young, lower educated and of a migrant background. Now the gig-economy conjures up images of Uber driver and Deliveroo bikes, two very recent phenomena. However, the increases in income volatility aren’t recent at all. Work by Andersen et al describes in great detail how the income volatility has been increasing since the 1970s, through changing labor markets (shift of economic risk from employers to employees as marked by decreasing job security and employer-provided benefit) and the growth of part-time and temporary positions. They also warn that the implications of income volatility are greatest for low income families as they have fewer resources to manage volatility. Despite the families employing a number of coping strategies when faced with income volatility, these strategies are rarely enough and often carry their own risks to long-term financial and familial stability. If you were to be increasingly interested in how people cope with income volatility and the strategies they come up with you could do worse than read the US financial diaries. The USFD tracked 235 low- and moderate-income households over the course of a year to collect highly detailed data on how families manage their finances on a day-to-day basis. This work was highly qualitative and revealed that the main determinant of being just over or being kicked back under the poverty line was entirely determined by income volatility – and the families’ abilities to be able to somewhat predict and cope with changes in their income. The research produced several “issue briefs” focusing on topics of savings, savings horizons, spikes and dips and the aforementioned strategies the families (try to) apply. I would do the work no justice trying to quickly summarize it here, but especially the latter brief on strategies is an eye opener. The kicker to come out of that work is the following: “When asked whether they’d prefer to have more income or more stable income, the majority chose to have more stable income”. Wage increases or multiple income streams to increase income aren’t going to fix what’s going on here.
From the perspective of the private and public sector there’s lots of unchartered territory here. The work by research by Addo & Servon indicated that whatever fintech is currently out there isn’t helping people with their volatile incomes, so there’s gains to be made there. In terms of the public sector, there is a need for further understanding what people on volatile incomes need, as well as a revisiting of the trend to increasingly shift risks away from the employer, onto the employee. All in all, there’s a lot of work to be done here in furthering our understanding of the effects of volatile income, and the tools and policies required to deal with it properly – and by dealing with it properly I mean offsetting its detrimental effect. And no, I do not believe that consumption-smoothing tools like credit cards and BNPL are going to do it.