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Lifecycle Impacts of the Financial and Economic Crisis on Household Optimal Consumption, Portfolio Choice, and Labor Supply

Authors

Abstract

The direct financial impact of the financial crisis has been to deal a heavy blow to investment-based pensions; many workers lost a substantial portion of their retirement saving. The financial sector implosion in turn produced an economic crisis for the rest of the economy via high unemployment and reduced labor earnings, which reduced contributions to Social Security and private pensions. Our research asks which types of individuals were most affected by these dual financial and economic shocks, and it also explores how people may react by changing their consumption, saving and investment, work and retirement, and annuitization decisions. We do so with a realistically calibrated lifecycle framework allowing for time-varying investment opportunities and countercyclical risky labor income dynamics. We show that households near retirement will reduce both short- and long-term consumption, boost work effort, and defer retirement. Younger cohorts will initially reduce their work hours, consumption, saving, and equity exposure; later in life, they will have to work more, retire later, consume less, invest more in stocks, and save more.

Key Findings

  • We examine how households may be affected by a dual financial and economic crisis, such as the one recently experienced, in the short- and long-run.
  • We develop a lifecycle model to explore how people might react to such shocks by adjusting their consumption/saving patterns, investment/annuitization paths, work hours, and retirement patterns.
  • When young households are hit badly by the financial/economic crisis, they must reduce their work effort during the crisis by up to 10 percent. Later in life, they must boost work hours substantially – over 20 percent at age 60, and must defer retirement by one year on average. Lifetime consumption is lower in their early 20s and even after age 70. They must save substantially more later in life to build up financial wealth and will have lower stock investment.
  • When older households are badly hit by unemployment and stock market shocks, they must substantially boost their work effort by over 20 percent in their early 60s. They must postpone retirement by about one year, on average. They experience consumption losses in the short-term as well as later in life. Withdrawal of financial assets during the crisis results in substantial cuts in withdrawals later in life.

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Project

Paper ID

WP 2011-246

Publication Type

Working Paper

Publication Year

2011