Wage Rigidity and Retirement in Optimal Portfolio Choice

TL;DR

This paper derives explicit solutions for an agent's lifecycle portfolio choice problem with wage rigidity, stochastic income, and retirement, revealing how path-dependent wages influence optimal asset allocation strategies.

Contribution

It introduces a novel two-stage infinite dimensional stochastic control framework with explicit feedback controls, addressing the effects of wage rigidity and path dependency.

Findings

Explicit optimal controls in a complex stochastic setting

Wage rigidity impacts portfolio strategies and hedging demands

Path dependency modulates asset allocation predictions

Abstract

We study an agent's lifecycle portfolio choice problem with stochastic labor income, borrowing constraints and a finite retirement date. Similarly to arXiv:2002.00201, wages evolve in a path-dependent way, but the presence of a finite retirement time leads to a novel, two-stage infinite dimensional stochastic optimal control problem with explicit optimal controls in feedback form. This is possible as we find an explicit solution to the associated Hamilton-Jacobi-Bellman (HJB) equation, which is an infinite dimensional PDE of parabolic type. The identification of the optimal feedbacks is delicate due to the presence of time-dependent state constraints, which appear to be new in the infinite dimensional stochastic control literature. The explicit solution allows us to study the properties of optimal strategies and discuss their implications for portfolio choice. As opposed to models with Markovian dynamics, path dependency can now modulate the hedging demand arising from the implicit holding of risky assets in human capital, leading to richer asset allocation predictions consistent with wage rigidity and the agents learning about their earning potential.