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Investing Retirement Wealth? A Life-Cycle Model

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  • John Y. Campbell
  • Joao F. Cocco
  • Francisco J. Gomes
  • Pascala J. Maenhout

Abstract

If household portfolios are constrained by borrowing and short-sales restrictions, or by fixed costs of participating in risky asset markets, then alternative retirement savings systems may affect household welfare by relaxing these constraints. This paper uses a calibrated partial-equilibrium model of optimal life-cycle portfolio choice to explore the empirical relevance of these issues. In a benchmark case, we find ex-ante welfare gains equivalent to a 3.7% increase in consumption from the investment of half of retirement wealth in the equity market. The main channel through which these gains are realized is that the higher average return on equities permits a lower Social Security tax rate on younger households, which helps households smooth their consumption over the life cycle. There is a smaller welfare gain of 0.5% of consumption when Social Security tax rates are held constant. We also find that realistic heterogeneity of risk aversion and labor income risk can strongly affect optimal portfolio choice over the life cycle, which provides one argument for a privatized Social Security system with an element of personal portfolio choice.

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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1896.

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Date of creation: 2000
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Handle: RePEc:fth:harver:1896

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