Labor supply flexibility and portfolio choice in a life cycle model

This paper examines the effect of the labor-leisure choice on portfolio and consumption decisions over an individual's life cycle. The model incorporates the fact that individuals may have considerable flexibility in varying their work effort (including their choice of when to retire). Given this flexibility, the individual simultaneously determines optimal levels of current consumption, labor effort, and an optimal financial investment strategy at each point in his life cycle. We show that labor and investment choices are intimately related. The ability to vary labor supply ex post induces the individual to assume greater risks in his investment portfolio ex ante.     

FLEXIBLE RETIREMENT

Flexible retirement – that is, the opportunity to choose one's own personal retirement age – is a hedge against pension risk and provides insurance to workers facing health or productivity shocks. Flexible retirement and flexible pension schemes are in practice closely linked because of imperfect capital markets and institutional restrictions. I discuss three necessary conditions to provide insurance through flexible retirement. First, it should be possible to adjust the pension starting date at limited cost. This condition is gradually being fulfilled, as many countries are moving toward more actuarially neutral pension schemes. Second, individuals should be willing to adjust their labor supply in case of a wealth shock. This condition seems largely fulfilled, although the available empirical evidence suggests that the ‘standard retirement age’ is at least as important as the income effect. Third, the labor market should be able to deal with flexible individual retirement decisions. This condition is gaining importance, but has not yet received much attention in the literature. Institutions often hamper employment past the ‘standard retirement age’. Moreover, the hiring rates of older workers are low and their unemployment duration is high. Institutional reforms facilitating flexible retirement opportunities are desirable from an insurance perspective.     

Labor supply,income, and welfare of the farm household

Considering family labor and hired labor as heterogeneous inputs, we present a theoretical framework in which the optimal decisions of a farm household on on-farm family and hired labor, off-farm labor supply, and leisure are determined uniquely and endogenously. Focusing on two alternative settings with and without off-farm employment constraints, we show that imperfect substitutability between family labor and hired labor is not critical to the separation of household production and consumption. The validity of the separation proposition is shown to depend crucially on whether or not the availability of off-farm job opportunities is limited. We further examine how changes in external economic conditions and government policies affect the time allocation decisions of the household, as well as the composition of household income (i.e., on-farm income and off-farm labor earnings).     

The timing of retirement — New evidence from Swiss female workers

We investigate the responsiveness of individual retirement decisions to changes in financial incentives. A reform increased women's normal retirement age (NRA) in two steps from age 62 to age 63 first and then to age 64. At the same time retirement at the previous NRA became possible at a benefit discount. Since the reform affected specific birth cohorts we can identify causal effects. We find strong and robust behavioral effects of changes in financial retirement incentives. A permanent reduction of retirement benefits by 3.4% induces a decline in the age-specific annual retirement probability by over 50%. The response to changes in financial retirement benefits varies with educational background: those with low education respond most strongly to an increase in the price of leisure.     

Age-dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners

A defined contribution pension plan allows consumption to be redistributed from the plan member's working life to retirement in a manner that is consistent with the member's personal preferences. The plan's optimal funding and investment strategies therefore depend on the desired profile of consumption over the lifetime of the member. We investigate these strategies under the assumption that the member is a rational life cycle financial planner and has an Epstein–Zin utility function, which allows a separation between risk aversion and the elasticity of intertemporal substitution. We also take into account the member's human capital during the accumulation phase of the plan and we allow the annuitisation decision to be endogenously determined during the decumulation phase.We show that the optimal funding strategy involves a contribution rate that is not constant over the life of the plan but is age-dependent and reflects the trade-off between the desire for current versus future consumption, the desire for stable consumption over time, the member's attitude to risk, and changes in the level of human capital over the life cycle. We also show that the optimal investment strategy during the accumulation phase of the plan is ‘stochastic lifestyling’, with an initial high weight in equity-type investments and a gradual switch into bond-type investments as the retirement date approaches in a way that depends on the realised outcomes for the stochastic processes driving the state variables. The optimal investment strategy during the decumulation phase of the plan is to exchange the bonds held at retirement for life annuities and then to gradually sell the remaining equities and buy more annuities, i.e., a strategy known as ‘phased annuitisation’.     

How to invest over the life cycle: Insights from theory

We analyse the state of the art in the field of life cycle portfolio choice, a recent strand of the literature on intertemporal portfolio selection. Life cycle models are designed to identify optimal savings and portfolio policies over the lifetime of investors. They can help to improve pension schemes by showing how these could be specifically tailored to the individual employee’s circumstances to overcome the ‘one-size-fits-all’ philosophy still prevailing in parts of the mandatory retirement savings system. To facilitate comparison, we first describe set-up, solution method and characteristic results for a basic model and then derive a general framework to classify existing contributions. We highlight the models’ strengths and weaknesses and assess their ability to resolve existing portfolio puzzles. Lessons from the literature are summarized and promising areas for further research identified. JEL classifications G11, D14, D91, H55     

Homeownership and mixed-asset portfolio allocations

Homeownership represents both a consumption and an investment decision for individuals. Considering the investment benefits of the home, we estimate the total returns and risk associated with the investment in single-family homes. Then, using a mean–variance utility function, we consider the impact of homeownership and mortgage loan financing on the optimal asset allocation decisions of individuals and contrast this with advice that does not include the home as part of the portfolio. While optimal portfolio weights are dependant upon both the degree of risk aversion of the individual investor and the relative importance of the home in the overall net worth picture, we show that, in general, the higher the home-to-net worth ratio, the higher the optimal portfolio allocation to stock. For most investors, including the home in the optimization decision leads to higher allocations to risky stock than suggested by traditional advice that ignores the home.     

Labor supply and the optimality of Social Security

Traditional economic theory predicts that an unfunded public pension system can be justified on the basis of its ability to provide intergenerational transfers, and also for its ability to provide partial insurance against mortality and labor income risks. In this paper, I demonstrate that the quantitative importance of these traditional roles depends on how the pension system distorts households' labor supply decisions. Using a general-equilibrium life-cycle consumption model calibrated to the U.S. economy, I show that these distortions can be large enough to erase much of the traditional welfare gains from Social Security. I also find that this fact is robust within the range of labor supply elasticities usually encountered in the macroeconomic literature.     

The great recession and changes in faculty expected retirement age

The great recession of 2008 has shifted retirement plans of workers in general. This paper examines the changes in expected retirement age following the great recession of 2008 of a subset of the labor force—university faculty who are near retirees and participate in a defined contribution retirement plan. We find evidence consistent with the life-cycle model which predicts changes in expected retirement age when there are unexpected changes in retirement wealth. For the faculty who expected to delay planned retirement, the average delay is 4 years. Regression estimates indicate a longer time horizon moderates the delay in expected retirement. We also find evidence that expected wealth at retirement amplifies the delay in expected retirement age while current value of retirement wealth moderates the delay in planned retirement.     

Education,lifetime labor supply,and longevity improvements

This paper presents an analysis of the differential role of mortality for the optimal schooling and retirement age when the accumulation of human capital follows the so-called “Ben–Porath mechanism”. We set up a life-cycle model of consumption and labor supply at the extensive margin that allows for endogenous human capital formation. This paper makes two important contributions. First, we provide the conditions under which a decrease in mortality leads to a longer education period and an earlier retirement age. Second, those conditions are decomposed into a Ben–Porath mechanism and a lifetime-human wealth effect vs. the years-to-consume effect. Finally, using US and Swedish data for cohorts born between 1890 and 2000, we show that our model can match the empirical evidence.     

HOW SENSITIVE ARE RETIREMENT DECISIONS TO FINANCIAL INCENTIVES? A STATED PREFERENCE ANALYSIS

We study the effects of financial incentives on retirement decisions using stated preference data. Dutch survey respondents were given hypothetical retirement scenarios describing age(s) of (partial and full) retirement and replacement rate(s). A stylized model is estimated in which utility is the discounted sum of within‐period utilities that depend on employment status and income. Parameters of the utility function vary with observed and unobserved characteristics. Simulations show that the income and substitution effects of pensions as a function of the retirement age are substantial and larger than according to studies using data on actual retirement decisions in the Netherlands. Copyright © 2013 John Wiley & Sons, Ltd.     

The consumption–investment decision of a prospect theory household: A two-period model

This study extends the literature on portfolio choice under prospect theory preferences by introducing a two-period life cycle model, where the sufficiently loss averse household decides on optimal consumption and investment in a portfolio with one risk-free and one risky asset. The optimal solution depends primarily on whether the household’s present value of the consumption reference levels is below, equal to, or above the present value of its endowment income. Reference levels below the endowment income are associated with the self-enhancement motive. In this case, the household avoids relative losses in consumption in any present or future state of nature (good or bad). As a result the degree of loss aversion does not directly affect optimal consumption and risk taking activity. Reference levels equal to the endowment income are associated with the belonging motive. An example would be a household comparing to others that belong to the same social class. In this case the household’s optimal consumption is the reference consumption and the household will not invest in the risky asset. Finally, reference levels above the endowment income are associated with the self-improvement motive (or high aspirations). For such high reference levels, households cannot avoid experiencing a relative loss in consumption, either now or in the future. As a result, loss aversion directly affects consumption and risky investment.     

Asset allocation over the life cycle: How much do taxes matter?

We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems – a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.     

NIT picking: The macroeconomic effects of a Negative Income Tax

I study a revenue-neutral reform of the U.S. income tax and welfare system that involves the adoption of a Negative Income Tax (NIT). The reform is undertaken in a life-cycle economy with individual heterogeneity and uninsurable idiosyncratic labor risk. The optimal NIT consists of a 22% rate and a transfer equivalent to 11% of per-capita GDP. The ex-ante average welfare gain is a 2.1% annual increase of individual consumption. I show that a NIT outperforms a flat tax reform (income tax plus deduction) by a considerable margin. The key consequence of the reform is that high-productivity agents increase their relative importance in the labor supply at the expense of low-productivity agents.     

Competitive equilibrium cycles with endogenous labor

In this paper, we study a two-sector optimal growth model with elastic labor supply. We show that the modified golden rule is saddle-point stable when the investment good is capital intensive. To characterize stability with a capital intensive consumption good, we focus on either additively separable or homothetic preferences. In the first specification, we show that optimal oscillations require the elasticity of intertemporal substitution in consumption to be high enough while the elasticity of labor needs to be low enough. At the same time, we prove that with a linear utility in leisure the modified golden rule is always saddle-point stable. In the second specification for preferences, we show that the local dynamic properties of the optimal path depend instead on the shares of consumption and leisure into total utility. We prove that endogenous fluctuations are even more likely with homothetic preferences.     

The financial investment decision of non-financial firms in China

This paper constructs a portfolio model to analyze the determinants of the financial investment decision of non-financial firms in China. Unlike the literature assuming that financial investments are riskless, our model allows risks in both fixed and financial investments. We show that this extension provides an analytically similar but economically different model from the literature. In particular, it is relative risk and risk-adjusted return gap, not pure risk and simple return gap that enter into firms’ financial investment decision model. Using firm-level panel data of 1902 firms listed in Chinese stock market over the period from 2006 to 2016 with semi-annual frequency, we find that the ratio of fixed investment risk over total risk dominates financial investment decisions of non-financial firms. However, rates of risk-adjusted return gap between financial and fixed investments play no role in Chinese firms’ financial investment decisions, which is in stark contrast to the results using a model assuming riskless financial investments. The baseline findings are robust to alternative measures of financialization and investment risk and different firm sizes, ownership structures and time periods.     

Tax enforcement policies,tax evasion and time allocation

Several studies examine the effect of tax rates on households’ labor supply decisions in attempts to account for observed differences in work hours across countries. Interestingly, these studies fail to consider a fundamental action associated with taxation: tax evasion. This paper introduces, into a general equilibrium model of household labor supply, the possibility that households can evade labor income taxes. We show that the relationship between tax-enforcement policies, the elasticity of substitution between consumption and leisure and the elasticity of substitution between formal and informal work is key to explain formal labor supply in major OECD countries. In a model without informal work, there is a positive relationship between the elasticity of substitution and the tax rate on formal income and people tend to work more. This is the case for the United States, Greece, Finland and the United Kingdom. This relationship becomes negative once informal activities are introduced and the model can explain formal labor supply better in countries where agents work relative less, i.e., in Austria, Denmark, France, Germany, Spain, Norway and Sweden. We also obtain estimates of hours worked in the informal sector for these countries.     

Optimal portfolio choice in the presence of domestic systemic risk: empirical evidence from stock markets

In this paper, we empirically investigate the consequences of domestic systemic risk for stock market investors. To tackle this issue, we consider two different investment strategies. One strategy is to be “crisis-conscious”, i.e., taking the possibility of systemic events into account, and the other one is to be “crisis-ignorant” and thus disregarding systemic risk. We compare the optimal portfolio choices and investment results of these strategies in an historical simulation, using almost three decades of historical stock price data. Our main findings are as follows: the crisis-conscious investor tends to choose less extreme portfolio weights for individual stocks than the ignorant investor. The overall risky investment is, however, of similar size for both. By ignoring the possibility of systemic events, the crisis-ignorant strategy performs significantly worse from the viewpoint of expected return as well as expected utility.     

Structural estimation of stock market participation costs

This paper develops and estimates a dynamic model of stock market participation, where consumers' decisions regarding stock market participation are influenced by participation costs. The practical significance of the participation costs is considered as being a channel through which financial education programs can affect consumers' investment decisions. Using household data from the Panel Study of Income Dynamics, I estimate the magnitude of the participation cost, allowing for individual heterogeneity in it. The results show the average stock market participation cost is about 4–6% of labor income; however, it varies substantially over consumers' life. The model successfully predicts the level of the observed participation rate and the increasing pattern of stock market participation over the consumers' life cycle.     

Spousal Complementarity in Home Production

A bstract .   Economists have increasingly recognized the growing role of married women in the labor market by treating the labor supply decisions of married couples as joint decisions. However, they have yet to apply the same reasoning to home production. We build a more complete model of household time allocation that consists of a system of simultaneous equations estimating hours of labor supply and home production. Using data on white couples from Wave XXV of the Panel Study of Income Dynamics, we find that working wives act as if their husbands are substitutes for home production while other wives do not. Husbands' responses to their wives' behavior depends upon whether children are present.