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How does retirement affect optimal life cycle portfolio allocation between stocks and bonds?

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Abstract

Portfolio allocation decisions over the life cycle depend, among many factors, on the retirement income as well as risks and choices faced in retirement. However, due to computational complexity, many retirement factors are typically assumed away. By building on the standard life cycle investment-consumption model that includes a more realistic progressive retirement income program, I discuss how each aspect of retirement income affects optimal portfolio allocation over the life cycle. I find that all investors across all scenarios maintain high levels of stocks in their portfolios at a young age. However, investors who face low net replacement rates, risk of forced retirement, or retirement income uncertainty hedge these risks by accumulating higher private savings and reducing risky portfolio shares at an earlier age. In a realistic setting with early forced retirement risk and endogenous retirement timing, optimal equity portfolio share temporarily increases once the investor becomes eligible for retirement. Retirement income’s dependency on workers’ lifetime labor earnings is not, however, an important factor in portfolio allocation over the life cycle.

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Notes

  1. Gomes (2020) provides a survey of the recent literature.

  2. The exception is Chen et al. (2020) who study portfolio choice with forced retirement risk.

  3. Their rule is to invest 100% in stocks up to the age of 40, then reduce equities by 2.5 percentage points per year until the portfolio is evenly split between stocks and bonds, and maintain that in retirement.

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  1. Department of Economics, Weber State University, 1337 Edvalson St, Ogden, UT, 84408, USA

    Valentinas Rudys

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Rudys, V. How does retirement affect optimal life cycle portfolio allocation between stocks and bonds?. J Asset Manag 24, 212–224 (2023). https://doi.org/10.1057/s41260-022-00298-6

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