Optimal Consumption and Investment with Labor Income Uncertainty and Endogenous Retirement

44 Pages Posted: 21 Sep 2004

See all articles by Matthew M. Woolley

Matthew M. Woolley

University of North Carolina (UNC) at Chapel Hill - Department of Economics

Date Written: October 2004

Abstract

This paper characterizes optimal consumption and investment policies for investors with asset return predictability, stochastic labor income and endogenously-determined retirement. We find that the ratio of total wealth-to-labor income (normalized wealth) is the primary determinant of the retirement decision and that at all ages, there exists a critical normalized wealth such that above this wealth, investors retire. We further consider the implications of endogenous retirement on portfolio choice. It is well known that human capital plays a large role in the determination of optimal equity proportion in financial portfolios. By endogenizing retirement, human capital becomes dependent on savings and investment decisions, which in turn depend on human capital. When compared to investors who exogenously retire at age 65, we find that low-wealth investors with the option to time retirement invest more aggressively while investors with slightly greater normalized wealth invest less aggressively prior to retirement. Investors with high normalized wealth behave almost the same as in the exogenous retirement case. This result contrasts the results in two recent papers and is due to the existence of stochastic labor income. Finally, we consider the impact of asset return/labor income correlation and find that equity holdings are nearly completely crowded-out by increased labor income (background) risk.

Keywords: Life-cycle, portfolio allocation, stochastic labor income, endogenous retirement

JEL Classification: D91, E21, G11, J26

Suggested Citation

Woolley, Matthew M., Optimal Consumption and Investment with Labor Income Uncertainty and Endogenous Retirement (October 2004). Available at SSRN: https://ssrn.com/abstract=593803 or http://dx.doi.org/10.2139/ssrn.593803

Matthew M. Woolley (Contact Author)

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

HOME PAGE: http://www.unc.edu/~woolleym