Working Paper: NBER ID: w26784
Authors: Jason S. Scott; John B. Shoven; Sita N. Slavov; John G. Watson
Abstract: Simple presentations of the life cycle model often suggest a constant level of real consumption in retirement. Similarly, financial planners commonly suggest that people save for retirement in such a way as to enable them to maintain a level retirement standard of living equal to their standard of living while working. However, constant consumption with age is only optimal under the precise and unlikely condition that the subjective rate of time preference is equal to the real interest rate. Most people exhibit a positive rate of pure time preference and additionally discount the future by both mortality and morbidity risks. In comparison, the real interest rate is roughly zero percent and the term structure of interest rates suggests that this condition is likely to persist. These considerations suggest that optimal consumption in the life cycle model declines with age. This finding has major implications for optimal retirement saving. For instance, we find that for many, perhaps most, people in the bottom half of the lifetime earnings distribution, it is optimal to spend out their retirement wealth well before death and to live on Social Security alone after that. Very low earners may find it optimal to not engage in retirement saving at all.
Keywords: retirement savings; life cycle model; optimal consumption; financial planning; social security
JEL Codes: D14; D15; H55; J26
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal consumption declines with age (D15) | low retirement savings (D14) |
| positive rate of pure time preference + mortality and morbidity risks (D15) | optimal consumption declines with age (D15) |
| declining consumption pattern (D12) | lower need for retirement savings (J26) |
| low interest rates + high mortality risks (G22) | declining consumption pattern (D12) |
| individuals in the lower half of the earnings distribution (D31) | exhaust retirement savings before death (D14) |
| poor health states (I12) | lower expected utility from consumption (D11) |