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

21 Pages Posted: 23 Apr 2008 Last revised: 31 Aug 2010

See all articles by Francisco Gomes

Francisco Gomes

London Business School

Laurence J. Kotlikoff

Boston University - Department of Economics; National Bureau of Economic Research (NBER); Gaidar Institute for Economic Policy

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Date Written: April 2008

Abstract

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.

Suggested Citation

Gomes, Francisco and Kotlikoff, Laurence J. and Viceira, Luis M., Optimal Life-Cycle Investing with Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds (April 2008). NBER Working Paper No. w13966. Available at SSRN: https://ssrn.com/abstract=1122754

Francisco Gomes

London Business School ( email )

Institute of Finance and Accounting
Sussex Place - Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

HOME PAGE: http://www.london.edu/faculty/fgomes

Laurence J. Kotlikoff

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-4002 (Phone)
617-353-4449 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Gaidar Institute for Economic Policy

Gazetny per. 5-3
Moscow, 125993
Russia

Luis M. Viceira (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6331 (Phone)
617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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