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

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

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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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 98 (2008)
Issue (Month): 2 (May)
Pages: 297-303

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Handle: RePEc:aea:aecrev:v:98:y:2008:i:2:p:297-303
Note: DOI: 10.1257/aer.98.2.297
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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, vol. 112(1), pages 1-55, February.
  2. 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.
  3. Eugene Fama & F. & Kenneth R. French, . "The Equity Premium."," CRSP working papers 522, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  4. Zvi Bodie & Robert C. Merton & William F. Samuelson, 1992. "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model," NBER Working Papers 3954, National Bureau of Economic Research, Inc.
  5. Bodie, Zvi & Detemple, Jerome B. & Otruba, Susanne & Walter, Stephan, 2004. "Optimal consumption-portfolio choices and retirement planning," Journal of Economic Dynamics and Control, Elsevier, vol. 28(6), pages 1115-1148, March.
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