Working Paper: NBER ID: w17025
Authors: Jialun Li; Kent Smetters
Abstract: This paper re-examines the classic question of how a household should optimally allocate its portfolio between risky stocks and risk-free bonds over its lifecycle. We show that allowing for the wage indexation of social security benefits fundamentally alters the optimal decisions. Moreover, the optimal allocation is close to observed empirical behavior. Households, therefore, do not appear to be making large "mistakes," as sometimes believed. In fact, traditional financial planning advice, as embedded in "target date" funds - whose enormous recent growth has been encouraged by new government policy - often leads to even relatively larger "mistakes" and welfare losses.
Keywords: portfolio choice; social security; wage indexation
JEL Codes: G11; H0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| wage indexation of social security benefits (J32) | alters household portfolio allocation decisions (G59) |
| wage indexation of social security benefits (J32) | correlation with stock returns (G17) |
| correlation with stock returns (G17) | influences optimal portfolio choices (G11) |
| wage-indexed social security benefits (J32) | affect perceived value of risky assets (G19) |
| affect perceived value of risky assets (G19) | optimal household portfolio decisions (G59) |