How to Invest and Spend Wealth in Retirement? A Utility-Based Analysis
By Servaas van Bilsen (University of Amsterdam), A. Lans Bovenberg (Tilburg University – Center for Economic Research (CentER); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)) & Roger J. A. Laeven (University of Amsterdam – Amsterdam School of Economics)
This paper explores the optimal consumption and investment behavior of a retiree who derives utility from the ratio between consumption and an endogenous habit. By developing a non-trivial linearization to the budget constraint, we are able to derive closed-form policies. This enables us to explicitly characterize how the preference parameters determine the optimal return and consumption smoothing mechanism and investment strategy. We also consider an extension which decouples relative risk aversion from the elasticity of intertemporal substitution. We show that under this extension habit formation no longer leads to unrealistically high median growth rates of consumption at the end of life.
Source: SSRN
