National Pension Hub Publications
Forced Retirement Risk and Portfolio Choice
Many Canadian and U.S. households are forced to retire before their anticipated retirement ages. We study the implication of this on the financial portfolio choice of households. In particular, we examine whether the conventional wisdom on the portfolio adjustment in late life, which suggests that households should reduce exposures to financial risks as they get older and enter retirement, is still valid under this forced retirement risk.
With the transition from the defined-benefit to defined-contribution pension system, households are taking more responsibilities in managing their retirement portfolios for better financial well-being in retirement. To determine an adequate level of financial risk in their retirement portfolio, and also to decide how to manage financial risk as they get older and retire, households need to figure out what other risks they face in late life. Our project sheds light on one significant risk that older households face, the forced retirement risk, which has been neglected in the literature. This project shows that this risk has an important implication on the financial portfolio management in late life.
Most financial advisors suggest reducing the share of risky assets in portfolio as households get older and retire. Most lifecycle funds in the market are designed based on this principle. The assumption behind this suggestion is that the labor income risks households face in late life are either small or not correlated with returns to risky assets. Our work shows that the most significant labor income risk in late life takes the form of uncertainty in retirement timing, which has been overlooked in literature. When we explicitly take this into account, the optimal portfolio adjustment turns out to be very different from what is suggested in the conventional wisdom: Households should have lower share of risky assets before retirement than after retirement. This finding will help financial advisors design a better portfolio adjustment strategy for older households in Canada and the U.S.
We first examine how likely older households in Canada and the U.S. are forced to retire, using household-level data including the Health and Retirement Studies for the U.S. and the Labour Force Survey for Canada. We examine the correlation between this risk and the returns to risky assets. We then bring these empirical findings to a calibrated structural model and examine the implication of this risk on optimal portfolio choice in late life.
Our preliminary analysis shows that many older households are forced to retire before their planned retirement ages and this becomes more likely when the returns to risky assets tend to be lower. The existence of such risk means households should lower exposure to financial risks before retirement than after retirement, contrary to the conventional wisdom. This finding will help design financial advices and lifecycle portfolios that better match needs of households close to retirement.
Minjoon Lee is an Assistant Professor of Economics at Carleton University in Ottawa, Canada. His main field of research is Macroeconomics and Household Finance. His research interests also include Survey Methodology and Computational Economics. His recent papers study the demand for flexible work schedules as well as the optimal financial portfolio choice in late life. He received B.A. and M.A. degrees from Korea University and a Ph.D. from the University of Michigan.