Optimal Portfolio Choice Over the Life Cycle with Social Security

38 Pages Posted: 9 Nov 2010

See all articles by Kent A. Smetters

Kent A. Smetters

University of Pennsylvania - Business & Public Policy Department; National Bureau of Economic Research (NBER)

Ying Chen

University of Pennsylvania - The Wharton School

Date Written: April 9, 2010

Abstract

This paper examines how households should optimally allocate their portfolio choices between risky stocks and risk-free bonds over their lifetime. Traditional lifecycle models in previous work suggest that the allocation toward stocks should start high (near 100%) early in life and decline over a person’s age as human capital depreciates. These models also suggest that, with homothetic utility, the allocation should be roughly independent of a household’s permanent income. The actual empirical evidence, however, indicates more of a “hump” shape allocation over the lifecycle; the lifetime poor also hold a smaller percentage of their portfolio in stocks relative to higher income groups. Households, therefore, appear to be making considerable “mistakes” in their portfolio allocation. Target date funds, which have grown enormously during the past five years, aim to simplify the investment process in a manner consistent with the predictions of this traditional model. We reconsider the portfolio choice allocation in a computationally-demanding lifecycle model in which households face uninsurable wage shocks, uncertain lifetime as well as a progressive and wage-indexed social security system. Social security benefits, therefore, are correlated with stock returns at a low frequency that is more relevant for lifecycle retirement planning. We show that this model is able to more closely replicate the key stylized facts of portfolio choice. In fact, when calibrated to the age-based income-wealth ratios found in the Survey of Consumer Finances, we demonstrate that the portfolio allocation “mistakes” being made by the vast majority of households actually lead to larger levels of welfare relative to the traditional advice incorporated in target date funds.

Keywords: Portfolio, Social Security, Income, Model, Retirement, Households, Wages, Lifecycle, Wealth, Allocation, Stocks, Correlation, Model

Suggested Citation

Smetters, Kent and Chen, Ying, Optimal Portfolio Choice Over the Life Cycle with Social Security (April 9, 2010). Pension Research Council Working Paper No. 2010-06, Available at SSRN: https://ssrn.com/abstract=1706245 or http://dx.doi.org/10.2139/ssrn.1706245

Kent Smetters (Contact Author)

University of Pennsylvania - Business & Public Policy Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6372
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ying Chen

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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