Hedging Labor Income Risk over the Life-Cycle

SSRN Electronic Journal, 2005

Empirical evidence shows that changes in aggregate labor income and stock market returns exhibit only weak correlation at short horizons. As we document below, however, this correlation increases substantially at longer horizons, which provides at least suggestive evidence that stock returns and labor income are cointegrated. In this paper, we investigate the implications of such a cointegrated relation for life-cycle optimal portfolio and consumption decisions of an agent whose non-tradable labor income faces permanent and temporary idiosyncratic shocks. We find that, under economically plausible calibrations, the optimal portfolio choice for the young investor is to take a substantial {\em short} position in the risky portfolio, in spite of the large risk premium associated with it. Intuitively, this occurs because the cointegration effect makes the present value of future labor income flows stock-like' for the young agent. However, for older agents who have shorter times-to-retirement, the cointegration effect does not have sufficient time to act, and the remaining human capital becomes more bond-like.' Together, these effects create a hump-shaped optimal portfolio decision for the agent over the life cycle, consistent with empirical observation.

We characterize the covariance structure between asset returns and labor income shocks for synthetic persons defined in terms of sex, education and birth cohort. The correlation of income shocks with both aggregate and own-industry equity returns tends to rise with educational attainment and, surprisingly, is negative for several sex-education groups. We then develop a tractable equilibrium life-cycle model with incomplete markets. We implement the model using the estimated covariance structure and other data in order to evaluate the portfolio choice and welfare implications of hedging with financial assets. There are large equilibrium risk-sharing gains from trading a ”full menu” of group-level assets, exceeding 15,000 dollars in present value for many persons, and a single asset can generate sizable gains for certain demographic groups. The hedging motive has significant consequences for the structure of the optimal portfolio. 1 1

2000

This paper develops and applies a simple graphical approach to portfolio selection that accounts for covariance between asset returns and an investor's labor income. Our graphical approach easily handles income shocks that are partly hedgable, multiple risky assets, many periods and life cycle considerations.

2009

seminar participants at the Penn Macro club, and the Board of Governors of the Federal Reserve System for their valuable comments and encouragement. We also thank Fatih Guvenen for kindly sharing his dataset. Of course, all errors are our own.

2011

The direct financial impact of the financial crisis has been to deal a heavy blow to investment-based pensions; many workers lost a substantial portion of their retirement saving. The financial sector implosion in turn produced an economic crisis for the rest of the economy via high unemployment and reduced labor earnings, which reduced contributions to Social Security and private pensions. Our research asks which types of individuals were most affected by these dual financial and economic shocks, and it also explores how people may react by changing their consumption, saving and investment, work and retirement, and annuitization decisions. We do so with a realistically calibrated lifecycle framework allowing for time-varying investment opportunities and countercyclical risky labor income dynamics. We show that households near retirement will reduce both short-and long-term consumption, boost work effort, and defer retirement. Younger cohorts will initially reduce their work hours, consumption, saving, and equity exposure; later in life, they will have to work more, retire later, consume less, invest more in stocks, and save more.

Cepr Discussion Papers, 2006

Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use CEX repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model …ts the joint evolution of consumption and income inequality well and delivers two main results. First, we …nd that permanent changes in income explain all of the increase in inequality in the 1980s and 90s. Second, we reconcile this …nding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income pro…les.

2011

Unexpected events such as job displacement, disability, and divorce can have negative effects on individual and family income. For many families, social insurance provided by the government plays an important role in buffering the impact of these shocks. However, on average, Americans depend more on private resources rather than the public sector to insure against these losses.

Journal of Monetary Economics, 2009

Inequality* Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use CEX repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model fits the joint evolution of consumption and income inequality well and delivers two main results. First, we find that permanent changes in income explain all of the increase in inequality in the 1980s and 90s. Second, we reconcile this finding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income profiles.

Journal of Financial Economics, 2012

We investigate the relationship between workers' labor income and capital market investment. Using a detailed Swedish data set on employment and portfolio holdings we estimate wage volatility, and labor productivity for Swedish industries and, motivated by theory, demonstrate that highly labor productive industries are more likely to pay workers variable wages. We also find that both levels and changes in wage volatility are significant in explaining changes in household investment portfolios. A household going from an industry with low wage volatility to one with high volatility will ceteris paribus decrease its portfolio share of risky assets by 25%, i.e., 7,750 USD. Similarly, a household that switches from a low labor productivity industry to one with high labor productivity decreases its risky asset share by 20%. Our results suggest that human capital risk is an important determinant of household portfolio holdings. * Preliminary version, comments are welcome. We have benefited from helpful comments

2005

This article solves a realistically calibrated life cycle model of consumption and portfolio choice with non-tradable labor income and borrowing constraints. Since labor income substitutes for riskless asset holdings, the optimal share invested in equities is roughly decreasing over life. We compute a measure of the importance of human capital for investment behavior. We find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller, except when we allow for a disastrous labor income shock. Moreover, we study the implications of introducing endogenous borrowing constraints in this incomplete-markets setting.