Extending Life Cycle Models of Optimal Portfolio Choice: Integrating Flexible Work, Endogenous Retirement, and Investment Decisions with Lifetime Payouts
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Abstract
This paper derives optimal life cycle portfolio asset allocations as well as annuity purchases trajectories for a consumer who can select her hours of work and also her retirement age. Using a realistically-calibrated model with stochastic mortality and uncertain labor income, we extend the investment universe to include not only stocks and bonds, but also survival-contingent payout annuities. We show that making labor supply endogenous raises older peoples’ equity share; substantially increases work effort by the young; and markedly enhances lifetime welfare. Also, introducing annuities leads to earlier retirement and higher participation by the elderly in financial markets. Finally, when we allow for an age-dependent leisure preference parameter, this fits well with observed evidence in that it generates lower work hours and smaller equity holdings at older ages as well as sensible retirement age patterns.
Key Findings
- Having access to annuities is positive and important in the life cycle context, as is labor market flexibility in the form of adjustable weekly work hours and retirement ages.
- People with flexible retirement and flexible work hours, in addition to annuitized saving, are much better off. Their gain in well-being is worth more than 62 percent of their first-year earnings.
- As Baby Boomers move towards retirement, traditional fixed-payout annuities will gradually be replaced by investment-linked payout annuities.
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Paper ID
WP 2009-204Publication Type
Working Paper