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Optimal Portfolio Choice with Wage-Indexed Social Security

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  • Jialun Li
  • Kent Smetters

Abstract

This paper re-examines the classic question of how a household should optimally allocate its portfolio between risky stocks and risk-free bonds over its lifecycle. We show that allowing for the wage indexation of social security benefits fundamentally alters the optimal decisions. Moreover, the optimal allocation is close to observed empirical behavior. Households, therefore, do not appear to be making large "mistakes," as sometimes believed. In fact, traditional financial planning advice, as embedded in "target date" funds – whose enormous recent growth has been encouraged by new government policy – often leads to even relatively larger "mistakes" and welfare losses.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17025.

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Date of creation: May 2011
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Handle: RePEc:nbr:nberwo:17025

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  1. Kjetil Storesletten & Chris Telmer & Amir Yaron, 2007. "Asset Pricing with Idiosyncratic Risk and Overlapping Generations," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(4), pages 519-548, October.
  2. Carol C. Bertaut & Michael Haliassos, 1996. "Precautionary portfolio behavior from a life-cycle perspective," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 542, Board of Governors of the Federal Reserve System (U.S.).
  3. Gourinchas, Pierre-Olivier & Parker, Jonathan A, 2000. "Consumption Over the Life-Cycle," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2345, C.E.P.R. Discussion Papers.
  4. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4853, C.E.P.R. Discussion Papers.
  5. Ian Ayres & Barry J. Nalebuff, 2008. "Life-cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk," NBER Working Papers 14094, National Bureau of Economic Research, Inc.
  6. Heaton, John & Lucas, Deborah, 1997. "Market Frictions, Savings Behavior, And Portfolio Choice," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 1(01), pages 76-101, January.
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Cited by:
  1. Marekwica, Marcel & Schaefer, Alexander & Sebastian, Steffen, 2013. "Life cycle asset allocation in the presence of housing and tax-deferred investing," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(6), pages 1110-1125.
  2. Fischer, Marcel & Kraft, Holger & Munk, Claus, 2013. "Asset allocation over the life cycle: How much do taxes matter?," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(11), pages 2217-2240.

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