How Persistent Low Expected Returns Alter Optimal Life Cycle Saving, Investment, and Retirement Behavior

Vanya Horneff, Raimond Maurer, Olivia S. Mitchell
2017 Social Science Research Network  
This paper explores how a capital market environment of persistent low returns influences saving, investing, and retirement decisions and behaviors, as compared to what in the past had been thought of as more "normal" financial conditions. Our calibrated lifecycle dynamic model with realistic tax, minimum distribution, as well as uncertain income, stock returns, and mortality and Social Security benefit rules produces results that agree with observed work, and claiming age behavior of U.S.
more » ... havior of U.S. households. During the work life, the individual we consider has the opportunity to use current cash on hand for consumption and investments. Some portion of the worker's pre-tax salary (up to a limit of $18K) can be invested into a tax-qualified 401(k)-retirement plan of the EET type. That is, contributions into the account and investment earnings on account assets are tax-exempt, while withdrawals are taxed. In addition, a worker can invest outside his retirement plan in risky stocks and riskless bonds. The individual pays taxes (labor income tax, Medicare, City and State Tax, Social Security tax). Our model allows for flexible work effort and retirement ages. The worker can retire and claim Social Security benefits between age 62 and 70. The parameter of our model are matched, so that the model generates a large peak at the earliest claiming age at 62, as we can see in the data. Also in line with the empirical evidence, our baseline results show a smaller second peak at the (system-defined) Full Retirement Age of 66. Abstract This Chapter explores how an environment of persistent low returns influences saving, investing, and retirement behaviors, as compared to what in the past had been thought of as more "normal" financial conditions. Our calibrated lifecycle dynamic model with realistic tax, minimum distribution, and Social Security benefit rules produces results that agree with observed saving, work, and claiming age behavior of U.S. households. In particular, our model generates a large peak at the earliest claiming age at 62, as in the data. Also in line with the evidence, our baseline results show a smaller second peak at the (system-defined) Full Retirement Age of 66. In the context of a zero return environment, we show that workers will optimally devote more of their savings to non-retirement accounts and less to 401(k) accounts, since the relative appeal of investing in taxable versus tax-qualified retirement accounts is lower in a low return setting. Finally, we show that people claim Social Security benefits later in a low interest rate environment.
doi:10.2139/ssrn.3076397 fatcat:rey7ukonw5bujm3z3tl2zhcv4m