Retirement spending problem under Habit Formation Model

TL;DR

This paper models optimal lifetime consumption for retirees considering habit formation, mortality, and pension income, solving a complex control problem numerically to analyze consumption patterns and annuitization decisions.

Contribution

It extends previous habit formation models by incorporating mortality and pension income, and solves the resulting high-dimensional problem numerically.

Findings

Consumption behavior varies with habit and age.

Optimal strategies depend on asset allocation and smoothing factors.

Results inform decisions on wealth annuitization at retirement.

Abstract

In this paper we consider the problem of optimizing lifetime consumption under a habit formation model. Our work differs from previous results, because we incorporate mortality and pension income. Lifetime utility of consumption makes the problem time inhomogeneous, because of the effect of ageing. Considering habit formation means increasing the dimension of the stochastic control problem, because one must track smoothed-consumption using an additional variable, habit $\bar c$. Including exogenous pension income $\pi$ means that we cannot rely on a kind of scaling transformation to reduce the dimension of the problem as in earlier work, therefore we solve it numerically, using a finite difference scheme. We also explore how consumption changes over time based on habit if the retiree follows the optimal strategy. Finally, we answer the question of whether it is reasonable to annuitize wealth at the time of retirement or not by varying parameters, such as asset allocation $\theta$ and the smoothing factor $\eta$.