Human Capital, Social Security, and Asset Allocation

Abstract

A model of labor income that includes volatility is developed based on longitudinal data. Numerical stochastic dynamic programming is then applied to the model to explore the effects of stochastic human capital and Social Security on optimal asset allocation and consumption decisions over the lifecycle for typical individuals. Optimal asset allocations are very stock heavy pre-retirement, and quite stock heavy post retirement. Individuals should adopt declining equity allocations while employed, and level to slightly rising equity allocations during a stochastic duration retirement. Consumption should typically slowly increase until late in retirement, when it will be forced to fall.

Keywords: human capital, Social Security, asset allocation, consumption, stochastic dynamic programming