Financial Risk, Retirement, Saving and Investment

32 Pages Posted: 19 Feb 2008

See all articles by Alan L. Gustman

Alan L. Gustman

Dartmouth College - Department of Economics; National Bureau of Economic Research (NBER)

Thomas L. Steinmeier

Texas Tech University - Department of Economics and Geography

Date Written: September 2006

Abstract

This paper considers the prospects for adding choice of portfolio composition to a life cycle model of retirement and saving, while preserving the ability of the model to continue to explain the course of saving and retirement. If eventually successful, such a modification might be used to improve understanding of retirement and saving behavior both under the current Social Security system, and under variations involving personal accounts. In particular we consider the implications of separating parameters that now reflect both risk aversion and time preference.

We explore a number of barriers to developing a specification that is consistent with observed saving, retirement and investment choices. In our previous model with exponential consumption, individuals would hold portfolios exclusively in stocks, contrary to observation. Changing the exponent of consumption can reduce stock holdings below 100%, but at the cost of implausible retirement behavior. Introducing a separate parameter for risk aversion can restore plausible retirement behavior, but the pattern of stock holdings is too high, especially at younger ages, for plausible values of the risk aversion parameter.

At the moment, no easy solution is at hand to this fundamental problem now being engaged by financial economists. This suggests that models of retirement and saving may, for the immediate future, be forced to constrain portfolio composition to correspond with levels observed in the data, postponing the inclusion of portfolio mix as a choice variable until further progress is made in modeling that behavior. This does not necessarily reduce the efficiency of life cycle models of retirement and saving. Rather it recognizes that portfolio choice may be influenced by behavior that is not fully consistent with that posed by a life cycle model. Individuals may, for example, be accepting recommendations from planners or firms that they would not otherwise follow if they fully understood how to balance risk and return in portfolio choice in the same way they balance risk and return in their saving and retirement decisions. If these behavioral considerations govern their portfolio choice, while retirement and saving are determined by life cycle considerations, a model that correctly constrains portfolio composition may in fact generate parameter estimates that accurately reflect the forces governing retirement and saving behavior.

Suggested Citation

Gustman, Alan L. and Steinmeier, Thomas L., Financial Risk, Retirement, Saving and Investment (September 2006). Michigan Retirement Research Center Research Paper No. WP 2006-130, Available at SSRN: https://ssrn.com/abstract=1095004 or http://dx.doi.org/10.2139/ssrn.1095004

Alan L. Gustman (Contact Author)

Dartmouth College - Department of Economics ( email )

6106 Rockefeller Center
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603-646-2641 (Phone)
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National Bureau of Economic Research (NBER)

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Thomas L. Steinmeier

Texas Tech University - Department of Economics and Geography ( email )

Lubbock, TX 79409-2101
United States
806-742-2201 (Phone)

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