Optimal Savings and Portfolio Choice with Risky Labor Income and Reference-Dependent Preferences

This paper explores the joint impact of reference-dependent preferences and non-tradable risky labor income on optimal savings and portfolio decisions. We develop
a non-trivial solution procedure to determine the optimal policies. Our results reveal that the impact of permanent labor income shocks on both the optimal savings rate and the optimal portfolio share is more pronounced under reference-dependent preferences than under CRRA preferences. In particular, we find that in a wide range of scenarios, individuals withdraw pension wealth already before retirement. Furthermore, we show that the optimal response of the savings rate and the portfolio share to a fall in labor income exhibits large heterogeneity across the ratio of consumption to the reference level. Finally, we find that the optimal policies are more conservative compared to the case with risk-less labor income and CRRA preferences.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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