Tuesday, August 12, 2008

Optimal portfolios for retirement

You are building up assets for retirement. What is the best portfolio to do this? This question has been studied before, but has neglected flexible labor supply. Indeed, if for some reason your retirement did not work out as expected, you should still have the option to work (again/more). Gomes, Kotlikoff and Viceira takes this idea to a calibrated life cycle model and come to the following conclusions.

First, no surprise, young people should start accumulating for retirement right away. But the accumulation of assets stops before retirement. Why? As wages decline typically after age 55, it is better to increase leisure and start drawing on assets.

Second, young people should invest fully in stocks and take advantage of the higher return in the long run. In the early thirties, they can start investing in bond, at an increasing share all the way to retirement. But the stock share always stays above 45%.

Third, once retired, draw first on the bonds, so that the stock share increases. Why would one want to increase the risk of the portfolio as one ages? It is not that risky, as there is fixed income from social security.

And what did flexible labor supply add to this? One needs to accumulate less assets for retirement, the self-insurance aspect being lessened. Also, it is possible to have a more risky portfolio and thus reap the benefits from the long-term equity premium over bonds. Finally, the modeling indicates that one should retire gradually. The only sudden shift in behavior is due to social security payments kicking in at 65.

5 comments:

worried said...

I wonder whether this analysis is still valid today, where there seems to be more risk than anticipated on the stock market.

VIlfredo said...

I think the authors assume here that the labor supply of older people is very flexible. This may not be true, and if it is, wages are much lower when you unretire as a Wal-Mart greeter.

Independent Accountant said...

Buy bonds? Hahahahaha!

Anonymous said...

Sad to see an accountant with so little understanding of retirement strategies.

Russ said...

As wages decline typically after age 55, it is better to increase leisure and start drawing on assets.

Most people already do this. It's called showing up to work and not working very hard. Consider it a form of retiring gradually. Example: me posting on the blog.