Risky Income, Life Cycle Consumption, and Precautionary Savings

Abstract

This paper argues that precautionary savings against uncertain income comprise a large fraction of aggregate savings. A closed-form approximation for life cycle consumption subject to uncertain interest rates and earnings is derived by taking a second-order Taylor-Series approximation of the Euler equations. Using empirical measures of income uncertainty, I find that precautionary savings comprises up to 56 percent of aggregate life cycle savings. The derived expression for n-period optimal consumption is easily implemented for econometric estimation, and accords well with the exact numerical solution. Empirical comparisons of savings patterns among occupational groups using the Consumer Expenditure Survey contradict the predictions of the life cycle model. Riskier occupations, such as the self-employed and salespersons, save less than other occupations, although this finding may in part reflect unobservable differences in risk aversion among occupations.