The Influence of Health Risks on the Optimal Portfolio Selection of Private Investors in the Life Cycle

The project is funded by Deutsche Forschungsgemeinschaft (DFG)

The objective of the project is to analyze financial consequences of health risks on optimal consumption and financial portfolio decisions of private investors in the context of a time-discrete, realistically calibrated lifecycle model. The investors have access to capital and insurance markets and they can decide on hours worked and on their retirement age, while they are exposed to longevity, capital market, labor market and health risks. Health risks, that have not been considered sufficiently in the financial literature so far, influence decisions of investors due to unexpected changes (a) in the survival probability in the intertemporal utility function, (b) in labor income and (c) in medical expenses. In addition to the statutory social security systems, there are two possibilities to insure against the negative developments of labor income or medical expenses. Private investors can create financial reserves which require an optimal investment decision with respect to the instruments available at financial markets (shares, interest rate instruments, pension schemes). Also, households can insure themselves through payments of insurance premiums with private insurance contracts (illness, nursing, occupational disability). The developed lifecycle model allows an interdependent analysis of the different decision and risk categories. In addition to closing an important gap in the literature, the results of the project are relevant for social and economic policy because of the ongoing reforms of the private and state social security systems.

A first paper has been published (see below). The paper assesses optimal life cycle consumption and portfolio allocations when households have access to Guaranteed Minimum Withdrawal Benefit (GMWB) variable annuities over their adult lifetimes. Our contribution is to evaluate demand for these products which provide access to equity investments with money-back guarantees, longevity risk hedging, and partially-refundable premiums, in a realistic world with uncertain labor and capital market income as well as mortality risk. Others have predicted that consumers will only purchase such annuities late in life, but we show that they will optimally purchase GMWBs prior to retirement, consistent with their recent rapid uptick in sales. Additionally, many individuals optimally adjust their portfolios and consumption streams along the way by taking cash withdrawals from the products. These products can substantially enhance consumption, by up to 10% for those who experience highly unfavorable experiences in the stock market.