The Role of Consumption and Listed Alternative Investments on the Lifetime-Ruin Probability of U.S. Households

Abstract:     
In light of the current subprime and financial crises, retirement planning has gained in importance. Many U.S. households have had to reevaluate their assets and their retirement plans (if they even had plans). Most U.S. households, however, find it difficult to assess their retirements and the attendant risks properly. Households that have noticed a need for action often fail to fully evaluate the effectiveness of any potential actions.

In this article we propose to solve the problem for different U.S. households: middle class, upper-middle class and upper class by estimating the risk to be alive when the financial portfolio falls short (life-time ruin probability). We further consider a reduction in consumption as well as portfolio diversification in listed alternative investments and its effect on the reduction of life-time ruin risk. The complex model we employ accounts for the stochastic total wealth accumulation including income, consumption, housing, debt, and saving dynamics (after inflation, tax, and transaction costs).

We find that the life-time ruin probability for all considered households is unacceptably high: For the middle class even 75%, and still 54% for the upper class. But, the risk of portfolio ruin can be substantially reduced if the household is willing to decrease living expenses by 30% and diversifies in a na¿ve diversified portfolio of listed alternative investments by 30%, even if we account for the financial crisis. Finally we find that the middle class households must reassess their living expenses in the short run since it can only reduce lifetime ruin risk to 25% even if it takes all suggested action. In comparison the middle class and upper-middle class can reduce its lifetime-ruin risk to a reasonable 14% and 12.6%, which can be further decreased with a professional financial planning of the liquid (financial) assets.

Number of Pages in PDF File: 57

Keywords: Alternative investments, financial planning, lifetime-ruin probability, retirement

JEL Classification: G01, G11, G17

working papers series