One of the biggest questions on the minds of retirees is, “Where is the economy headed?” There is good reason to ask this question. If you are thinking of retiring or have already retired, the economy could determine if your retirement will be prosperous or not. Of course, I am speaking about finances and not the most important things like family, friends, health, and spiritual well-being.

For many, economic concerns impact their peace of mind. Just go on the Internet and Google “where is the economy headed.” Over 20 million results come up. If you read articles written by economists, you may feel more confused than before you started your research. Some say the U.S. economy is going to expand and others say our economy is in store for a great retraction. How can we use logical reasoning and not get caught up in exhaustive numbers and opinions? I would like to share with you some things that help me and my clients to reasonably understand how our economy is fed and to understand if we will see an economic expansion or retraction. This provides a big picture view. What we are about to discuss does not reveal how the stock market is going to react in the next month. Rather, it gives an overview of how things might begin to look in the coming years.

What makes up the U.S. economy?

Let’s start with the basics. The measure used to determine the U.S. economy is Gross Domestic Product or GDP. What makes up GDP? GDP = personal consumption + gross investment + government spending + (exports – imports). The part of GDP that I want to focus on is personal consumption. The reason I think we should focus here is because it is the largest part of GDP. It equates to more than 70% of GDP.

In general terms, personal consumption is what individuals spend their money on. For example, it includes what we spend on food, clothing, housing, recreation, services, health care, and transportation. If you look at the chart, you will see that from 1982 to 2008, personal consumption increased year after year. Note that there was a decrease in spending in 2009. It is very important to understand why this happened. The first reaction someone may have when seeing this decline is to dismiss it due to our recent economic turmoil. There was a major decline in the stock market, right? A drop in personal consumption makes sense, right? Think back to 2001 and 2002. The U.S. stock market had a major decline, there was a terrorist attack in the U.S., and the war against terrorism started! Why was there not a decline in personal consumption then?

If personal consumption is responsible for more than 70% of the U.S. economy, then it is important to analyze it further. Fluctuations in personal consumption will likely make the U.S. economy expand or contract. If this is true, then we need to consider whether consumer spending will be more or less. To do this, we need to look at the spending habits of families and determine when they spend the most. What is the period of life when people spend the most money? Statistically, people spend the most from ages 45–54. Why? That’s when child-related expenses are highest. College is being paid for, and cars and other large ticket items are being purchased. The next step in the analysis is to look at the U.S. population and demographics. Baby boomers make up one of the largest segments of the U.S. population. The United States Census Bureau considers a baby boomer to be someone born between 1946 and 1964. There are an estimated 78 million U.S. baby boomers.

Let’s look at how this massive number of people impact the economy. Think about the big economic boom that started in the ’90s. Correlate that to the baby boomer generation. The oldest of the group started turning 45 years old in 1991 at an amazing rate of approximately 10,000 people per day. They entered the biggest spending phase of their life and the economy picked up steam. They were putting kids in college, buying bigger homes, and purchasing large ticket items. This continued until they started entering the next phase of life.

The oldest of this group will be turning 65 in 2011. A majority of baby boomers have lived through their biggest spending years. An estimated 37,000,000 baby boomers are now in the next phase of life. Think about yourself, your neighbors, and your friends. What is the next financial goal after the kids are out of school and you are 55 years old or older? Retirement! You are now in the savings phase of life preparing for retirement. Is there any kind of government stimulus that will motivate you to increase spending? No! You are saving everything. You want to retire and you have only a few years to get ready. This is one of the main reasons we have started to see declines in consumer spending. This trend will continue as the remaining baby boomers enter the savings phase. It only makes sense that the economy will slow as consumer demand declines. This, in turn, will affect stock prices. We likely will see unemployment remain high and perhaps get even worse for a while.

There is a bright side to this story. We have a very large generation being created right now known as Generation Y, also referred to as Echo Boomers. They are around 60 million strong and will eventually create economic growth again. It will take a few years before that cycle happens.

It is interesting to note that this same type of cycle occurred with the Japanese economy in the early ’90s. Japan’s equivalent of the U.S. baby boom generation is older. Japan’s baby boomers moved into their spending phase in the ’70s. Japan was the economic example for many other countries at the time. In the ’70s and ’80s their economy boomed. The Japanese Nikkei 225 (similar to the U.S. Dow Jones) skyrocketed from 10,000 in 1984 to nearly 40,000 in early 1990. Then this generation began to peak in number and entered their savings phase of life. What do you think happened? Their economy started to slow down. Consider that in 1995 the Nikkei 225 was at 20,000. By 2001, it had fallen to 10,000. That’s a 75% drop in value from the peak. In the same timeframe, home values fell drastically.

Everyone knows that when the economy starts to slow down, all that is needed is a government stimulus, right? Japan tried this. They pumped the equivalent of hundreds of billions of dollars into their economy in the ’90s and lowered interest rates to nearly 0%. Do you think it worked? You’re right, it did not. Many of their consumers had entered into a phase of life for saving. Nothing the government did encouraged them to spend more. A major difference between Japan and the U.S. is their population growth. Japan had discouraged family growth and did not have a new generation sufficiently large enough to grow their economy. They still have not fully recovered from this economic cycle.

As we focus on the U.S. economy and consider our demographics, it is reasonable to assume we are in for a few years of slow, declining economic conditions. Does this mean that you should not invest for growth? Not exactly. It means you need to have a plan that takes the overall situation into account. From 1985 to 2007, the “buy and hold” mantra was born. Most came to realize after the major stock market declines of 2001, 2002, 2008, and the beginning of 2009 that mantra should die. In the current investing environment, flexibility is crucial.

If you have created an income plan and are considering how to invest your funds, you will want to look at it differently than you have in the past. What is the right way to invest? There is not only one right way. As you talk to financial advisors, ask them what their opinions are about the economy and the stock market. If they do not have an opinion or give you broad, sweeping statements, I would encourage you to look somewhere else for an advisor. You want someone who considers many aspects of the economy and is specific in their investing approach. Do not use an advisor who gives a random 60% stocks/40% bonds allocation and tells you to “hang in there” when things start to fall.

I hope this has given you a basic overview of the U.S. economy. I don’t mean this to sound like doom and gloom. I think as people are educated about the economy, they can plan better. There are people that did not lose much in the downturns of 2001, 2002, 2008 and 2009. Why? They made changes. They were able to see things the majority of others didn’t. I hope this allows you to see some things you did not see earlier and it helps you to weather any future downturns.