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INVESTING RETIREMENT WEALTH: A LIFE-CYCLE MODEL – Time parameters and preferences

INVESTING RETIREMENT WEALTH: A LIFE-CYCLE MODEL - Time parameters and preferencesAdult age starts at age 20 for households without a college degree, and at age 22 for households with a college degree. The age of retirement is set to 65 for all households. The investor dies with probability one at age 100. Prior to this age we use the mortality tables of the National Center for Health Statistics to parameterize the conditional survival probabilities, r for j = 1,…T. We set the discount factor B to 0.96, and the coefficient of relative risk aversion 7 to 5. In variations of the benchmark case, we also consider investors who are extremely impatient with B = 0.80, comparatively risk-tolerant with 7 = 2, and extremely risk-averse with 7 = 10.
To estimate the labor income process we follow CGM (1998). Here we briefly describe the data and estimation method.
We use the family questionnaire of the PSID to estimate equations (2) and (3) which give labor income as a function of age and other characteristics. Families that are part of the Survey of Economic Opportunities subsample are dropped to obtain a random sample. Only households with a male head are used, as the age profile of income may differ across male- and female-headed households and relatively few observations are available for female-headed households. Retirees, non-respondents, students, homemakers, and household heads younger than 20 (22 for college-educated households) or older than 65 are also eliminated from the sample.
Like CGM and Storesletten, Telmer, and Yaron (1998a,b), we take a broad definition of labor income so as to implicitly allow for insurance mechanisms—other than asset accumulation—that households use to protect themselves against pure labor income risk. Such insurance mechanisms include welfare programs that effectively set a lower bound on the support of non-asset income, endogenous variation in the labor supply of both male and female household members, financial help from relatives and friends, and so on. Thus we define labor income as total reported labor income plus unemployment compensation, workers’ compensation, social security, supplemental social security, other welfare, child support and total transfers (mainly help from relatives), all this for both head of household and if present his spouse. Observations which still report zero for this broad income category are dropped. Labor income defined this way is deflated using the Consumer Price Index, with 1992 as the base year. The sample starts in 1970, so a household appears at most 24 times in the sample. Households with fewer observations are retained in the panel.