How to Invest Over the Life-Cycle in the Presence of Background Risk?

Abstract

This paper investigates the impact of health and labor income risk on portfolio choice in a realistically calibrated life-cycle model. The model shows that health risk reduces the desired exposure to risky assets, consistent with empirical findings. Moreover, the model’s prediction matches empirical evidence, including the labor supply-health-age profile and retirement behavior. Furthermore, extending the model to incorporate the stylized fact that medical expenses of elderly are more volatile than those of younger individuals suggests rebalancing the portfolio so that it becomes more conservative as an investor nears retirement. This investment strategy is consistent with target retirement funds offered by financial advisers, yet the model suggests that the next wave of life-cycle fund designs should focus on both the year and age of retirement rather than only on the year of retirement. In the presence of background risk and a high historical equity risk premium, social insurance and bequest motives play an important role in explaining observed low risky asset holdings and low withdrawals of savings in later life.

Keywords: Portfolio Choice, Household Finance, Health Risk, Labor Income Risk, Medical Expenditures, Life Cycle