Optimal retirement with long-run income risk

Abstract

We examine an optimal portfolio problem where an individual receives nontraded labor income and must decide how to allocate her wealth between a stock and a risk-free asset, while also determining the optimal time to retire. Specifically, we explore how incorporating long-run income risk by assuming that labor income and stock prices are cointegrated affects both the optimal asset allocation and retirement strategy. Our findings show that accounting for long-run income risk alters the optimal allocation to risky assets and the timing of retirement. This helps explain why younger individuals with limited wealth are less likely to participate in the stock market, whereas wealthier individuals tend to allocate more to risky assets. Moreover, our findings reveal a positive relationship between stock investment and retirement age, driven by the positive correlation between wealth at retirement and the chosen retirement age.