Life-Cycle Consumption, Asset Allocation, and Pension Design Under Non-Standard Preferences

Abstract

This paper uses a behavioral life-cycle model to analyze different pension schemes when people display non-standard consumption preferences and income-heterogeneity. Retirement resources depend on public pension benefits and individual savings accumulated over working life. Individual savings crucially depend on the choice between low-risk and high-risk assets, because there is a sizable return gap. Mainstream economic models do not adequately capture peoples’ life-cycle asset allocation patterns, that is, their investment in safe and risky assets. The proposed model makes a better prediction. I investigate whether a transition towards a funded pension scheme is desirable, and whether different income classes could benefit from different pension schemes. The rationale is that a non-funded pension component provides better downward risk protection for the low-income earners, whereas a funded pension component is more appealing to rent-seeking, high-income earners. Simulation results reveal that a funded pension scheme is most promising for all income classes — considering reasonable demographic and financial market projections for Germany.

Keywords: D11, D61, D81, D91, E21, E27, H31, J26

JEL Classification: Behavioral Decision-Making, Consumer Choice, Pension Design, Asset Allocation