Spending Elasticity and Optimal Portfolio Risk Levels
By David Blanchett, Jeremy Stempien
Research on optimal retirement strategies overwhelmingly assumes that the retirement income goal is effectively inelastic (or fixed), which implies the retiree household has neither the desire nor the ability to cut back on spending for the entire duration of retirement (which is often assumed to last 30+ years). This is an incredibly unrealistic assumption that has significant implications on a myriad of retirement decisions. This piece focuses on how spending elasticity impacts optimal portfolio risk levels for retirees using a utility function based on prospect theory, where the expected utility of income varies depending on the goal composition for that retiree (i.e., the percentage of the income that is fulfilling “needs” versus “wants”). Overall, the analysis suggests that ignoring spending elasticity can result in optimal portfolio risk levels that are significantly different than if spending elasticity is considered, where equity levels for younger retirees (e.g., age 60) tend to be more aggressive and equity levels for older retirees (e.g., age 80) tend to be more conservative.
Source: @SSRN
