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Optimal Life-Cycle Investing with Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds

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  • Francisco J. Gomes
  • Laurence J. Kotlikoff
  • Luis M. Viceira

Abstract

We investigate optimal consumption, asset accumulation and portfolio decisions in a realistically calibrated life-cycle model with flexible labor supply. Our framework allows for wage rate uncertainly, variable labor supply, social security benefits and portfolio choice over safe bonds and risky equities. Our analysis reinforces prior findings that equities are the preferred asset for young households, with the optimal share of equities generally declining prior to retirement. However, variable labor materially alters pre-retirement portfolio choice by significantly raising optimal equity holdings. Using this model, we also investigate the welfare costs of constraining portfolio allocations over the life cycle to mimic popular default investment choices in defined-contribution pension plans, such as stable value funds, balanced funds, and life-cycle (or target date) funds. We find that life-cycle funds designed to match the risk tolerance and investment horizon of investors have small welfare costs. All other choices, including life-cycle funds which do not match investors' risk tolerance, can have substantial welfare costs.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13966.

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Date of creation: Apr 2008
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Publication status: published as Francisco J. Gomes & Laurence J. Kotlikoff & Luis M. Viceira, 2008. "Optimal Life-Cycle Investing with Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds," American Economic Review, American Economic Association, vol. 98(2), pages 297-303, May.
Handle: RePEc:nbr:nberwo:13966

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  1. Carroll, Christopher D, 1997. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(1), pages 1-55, February.
  2. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, American Finance Association, vol. 57(2), pages 637-659, 04.
  3. Hamish Low, 2005. "Self-Insurance in a Life-Cycle Model of Labor Supply and Savings," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(4), pages 945-975, October.
  4. Bodie, Zvi & Detemple, Jerome B. & Otruba, Susanne & Walter, Stephan, 2004. "Optimal consumption-portfolio choices and retirement planning," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 28(6), pages 1115-1148, March.
  5. Bodie, Zvi & Merton, Robert C. & Samuelson, William F., 1992. "Labor supply flexibility and portfolio choice in a life cycle model," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 16(3-4), pages 427-449.
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  1. Optimal portfolios for retirement
    by Economic Logician in Economic Logic on 2008-08-12 07:39:00
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