Retirement Income Insurance: A Do-It-Yourself Approach

The recent market downturn highlighted the substantial impact that capital markets fluctuations can have on retirement wealth. A possible strategy to manage investment risk is to purchase guarantees (i.e. put options), which can be fairly expensive. As an alternative, this paper suggests that an individual can self-insure against poor market outcomes by adjusting his retirement date as a function of market returns. To analyze this strategy, we introduce an endogenous retirement date in Merton’s (1971) optional consumption and portfolio choice model. We show that with a flexible retirement date, the worker can effectively guarantee that his retirement wealth will not drop below an endogenously determined floor. The presence of this self-insurance may crowd out the demand for guarantees, which is consistent with the relatively small size of that market. In that context, our analysis suggests that an interesting guarantee design would make the guarantee payments contingent on the individual’s inability to work. Our analysis also reveals that a flexible retirement date increases the worker’s risk tolerance and allows him to invest a higher proportion of his wealth in risky assets. However, when the individual retires, this increased risk tolerance disappears and our results indicate that the new retiree should suddenly switch to a more prudent investment strategy. JEL Classification: E21, E22, J22, and J26.