A Life-Cycle Model with Unemployment Traps

Fabio C. Bagliano^ Carolina Fugazza^

Giovanna Nicodano^^
^Università di Torino and CeRP (Collegio Carlo Alberto)
^^Università di Torino, CeRP (Collegio Carlo Alberto) and Netspar

This draft: March 2018

Abstract
The Great Recession highlighted that long-term unemployment may become
a trap with loss of human capital. This paper extends the life-cycle model by
allowing for a small risk of long-term unemployment with permanent e¤ects on
labour income. Such nonlinear income risk dampens early investment in risky
assets, resulting in an optimal equity portfolio share that is relatively ‡at over the
life cycle. This ‡attening in the life-cycle pro…le is driven by the resolution of
uncertainty as the worker ages. Shifting away from a simple age rule to a ‡atter
investment pro…le yields average welfare gains that are three times larger than those
in models with linear labour income shocks.
Keywords: disaster risk, life-cycle portfolio choice, unemployment risk, human cap-
ital depreciation, age rule.
JEL classi…cation: D15, E21, G11

Address: Dipartimento ESOMAS, Università di Torino, Corso Unione Sovietica

218bis, 10134, Torino (Italy).
E-mails: [email protected]; [email protected]; [email protected]

We thank Antoine Bommier, Margherita Borella, Marie Brière, Claudio Campanale, Andrea Col-
ciago, Frank DeJong, Bernard Dumas, Jordi Gali, Stefano Giglio, Jerome Glachant, Francisco Gomes,
Michael Haliassos, Tullio Jappelli, Christian Julliard, Dirk Krueger, Elisa Luciano, Sidney Ludvigson,
Marco Pagano, Patrizio Tirelli, Ernesto Villanueva, Gianluca Violante and Bas Werker for very use-
ful comments and suggestions. We thank participants to the NETSPAR International Workshop on
Pensions, 2016, to the RiskForum2016 (Institut Louis Bachelier), to the to the CEPR Workshop on
Household Finance, 2016, to the RES 2017 and to the EEA 2017 annual conferences. We are grateful to
CINTIA-Italy for funding.

1
1 Introduction
Unemployment leads to large and persistent earnings losses that increase with the dura-
tion of unemployment because of skill deterioration. The magnitude of this e¤ect varies
over time and across industries and demographic groups (Rhum, 1991; Jacobson, Lalond
and Sullivan, 1993a; Davis and von Wachter, 2011) as well as countries (Machin and
Manning, 1999). Recently, the average length of unemployment spells has remarkably
increased in developed economies. For example, in the United States the share of unem-
ployed workers who are jobless for more than one year doubled during the Great Recession
episode, reaching 24% of total unemployment in 2014. Krueger, Cramer and Cho (2014)
and Kroft, Lange, Notowidigdo and Katz (2016) show that the re-employability of the
long-term unemployed progressively declines over time, to the extent that they are more
likely to exit the labour force than to become re-employed. The presence of more job
openings does not lead to increased employment among individuals who are jobless for
more than six months, and this pattern holds across all ages, industries and education
levels (Ghayad and Dickens 2012). Overall, these …ndings indicate that long-term unem-
ployment may become a trap, often unsupported by supplementary income provisions,
given that unemployment bene…ts usually decline rapidly as unemployment continues.
In this paper, we embed the possibility of entering long-term unemployment with per-
manent consequences on human capital in a life-cycle model of consumption and portfolio
choice. We model working life careers as a three-state Markov chain driving the transitions
between employment and short-term and long-term unemployment states, as in Bremus
and Kuzin (2014). Careers are calibrated to broadly match observed US labour market
features. Importantly, we allow for (a small probability of) human capital erosion during
unemployment. When unemployed, individuals receive bene…ts but simultaneously ex-
perience a reduction in the permanent component of labour income which translates to
diminished future income prospects. Permanent earning losses are subsequently observed
due to skill loss during long-term unemployment (Neal, 1995; Arulampalam, 2001; Edin
and Gustavsson, 2008; Schmieder, von Wachter and Bender, 2016).
Such potential loss in human capital considerably lowers the optimal portfolio share
invested in stocks compared with the case of no unemployment risk. Importantly, optimal
stock investment no longer decreases with age but remains remarkably ‡at over the whole
working life, in line with evidence on US portfolios (Ameriks and Zeldes, 2004). In
contrast, traditional life-cycle models imply that workers should reduce exposure to risky
stocks as they approach retirement (Bodie, Merton and Samuelson, 1992; Viceira 2001;
Cocco, Gomes and Maenhout 2005). Human capital provides a hedge against shocks
to stock returns, which makes …nancial risk bearing generally acceptable. Investment

2
in stocks should therefore be relatively high at the beginning of working careers, when
human capital is large relative to accumulated …nancial wealth. Investment then gradually
declines until retirement, as human capital decreases relative to …nancial wealth. The
implication of this model is embodied in the popular "age rule" which advises a gradual
decrease in stock exposure with increasing age. In our model with unemployment traps,
the e¤ect is instead moderated by the resolution of uncertainty concerning labour and
pension income as the worker safely approaches retirement age. Since the risk of long-term
unemployment falls along with human capital as retirement approaches, the resolution
of uncertainty compensates for the hedge e¤ect and the optimal investment in stocks
is relatively ‡at over the life cycle. Our model reinforces and complements the results
in Chang, Hong and Karabarbounis (2017). On the one hand the risk of falling in an
unemployment trap is present even for young highly educated workers who may ex-
ante be con…dent about their earnings ability. Thus, augmenting the model in Chang,
Hong and Karabarbounis (2017) with unemployment traps could improve its ability to
match the conditional stock investing observed in US data. Secondly, our insight implies
cross-country variation in the age pattern of stock investing depending on the degree of
long-term unemployment insurance. For example, our results may be able to explain
the decreasing age pro…le of conditional stock share in a country such as Norway (see,
Fagereng, Gottlieb and Guiso, 2017), where the net replacement rate for the long-term
unemployed has been fairly high.
The optimal risky portfolios are highly heterogeneous in models without long-term un-
employment traps. In contrast, the small probability of such personal disaster shrinks the
heterogeneity of optimal portfolio choices across agents characterized by di¤erent employ-
ment histories. In the face of possible, albeit rare, human capital depreciation, individuals
accumulate substantially more …nancial wealth during their working life to bu¤er against
possible adverse labour market outcomes. Optimal early consumption consequently falls,
becoming higher during both late working years and retirement years. The working-year
responses to unemployment risk, including the ‡at age pro…le in stock investment, are
remarkably robust to changes in preferences on the intertemporal correlation of shocks.
Allowing for Epstein-Zin preferences only causes slower wealth decumulation and less risk
taking during retirement years. Similarly, an increase in the correlation between stock re-
turns and labour income shocks leaves the ‡at shape of optimal equity investment during
working age unaltered, only increasing the portfolio share allocated to the risk-free asset.
Thus, unemployment risk due to uninsured long-term unemployment is the …rst-order
determinant of optimal …nancial risk taking at di¤erent ages.
This paper is not the …rst to explicitly connect life cycle precautionary savings to
social insurance in general (Hubbard, Skinner and Zeldes, 1995) and to insurance against

3
employment risk in particular (Low, Meghir and Pistaferri, 2010). Our analysis uncovers
the link between the share of long-term unemployment risk that is left uninsured and the
path of optimal equity risk taking during working years. In this respect, acknowledging
the presence of unemployment traps provides relevant consequences for the design of
pension fund default investment rules. Absent traps, welfare losses due to the use of
simple age rules are below of 1% annual consumption in standard calibrations (Cocco,
Gomes and Maenhout, 2005; Love, 2013); however, they are above 3% when allowing
for traps that unemployment bene…ts do not cover. Such losses easily reach 10% of
consumption for investment rules, mimicking those embedded in Target Date Funds.
These losses are due to both excessive …nancial risk taking when young workers confront
higher uncertainty about their future labour and pension income and by insu¢ cient
…nancial risk taking when this uncertainty is resolved. These suboptimal rules lead to
lower consumption during retirement.
The above results are obtained based on US data, where the risk of long-term un-
employment is small, but uniform across all education groups (e.g., see Kroft, Lange,
Notowidigdo and Katz 2016).1 The implied unconditional probabilities of being short-
run unemployed (3:8% ) or long-run unemployed (0.6%) are quite conservative. By com-
parison, the total US unemployment rate in 2016 was about 5%, while the long-term
(more than 52 weeks) unemployment rate was 1.7%.2 We set the unemployment bene…t
replacement rate at the average level observed in the United States. As for human capital
erosion, we set it equal to 0% and 60% in case of short-term and long-term unemployment
spells, respectively, to capture the relatively slow re-employment process experienced by
US workers caught in the trap. Importantly, we select the human capital erosion during
long-term unemployment considering both the total loss of human capital for the fraction
of workers abandoning the labour force, and the partial loss for those who are able to
…nd a job. Results go through even when the erosion parameter is substantially reduced,
and when the probability of moving into long-term unemployment from an initial un-
employment state is decreased by a third (from 0.15 to 0.10). We also experiment with
a stochastic human capital loss conditional on long-term unemployment, to represent
the possibility of incurring large losses only in very deep crisis situations rather than in
normal business cycle downturns. In this case, our results are con…rmed even when the
expected erosion is as low as 10%-20% of the permanent labour income component after
the second year of unemployment.
Previous life-cycle models with unemployment and self-insurance leave the observed
age pattern of stock holding during working life largely unexplained. Some versions of
1
For example, in 2013, the share of US unemployed workers with a high school (college) education
who had been looking for work for two or more years is 12.8% (13.5%) (see, Mayer, 2014).
2
Source: Labor Force Statistics from the Current Population Survey.

4
the life-cycle model account for the risk of being unemployed by introducing a (small)
positive probability of zero labour income. In these models, unemployment risk a¤ects
income only during the unemployment spell and has no consequences on subsequent earn-
ings ability (Cocco, Gomes and Maenhout, 2005), even when unemployment is persistent
(Bremus and Kuzin, 2014). With no permanent consequence on subsequent earnings abil-
ity, the stock holding still counterfactually decreases with age till retirement, although the
decrease is less on average than what occurs without unemployment risk. Thus, the pos-
sibility of unemployment traps - rather than unemployment per se - restrains risk taking
by young and middle-aged workers. Therefore, our model draws attention to a scenario
opposite that depicted by Bodie, Merton and Samuelson (1992) and Gomes, Kotliko¤
and Viceira (2008) in which the worker is able - if employed - to modify labour supply to
bu¤er income shocks. In fact, the ‡exible labour supply may enhance risk-taking, thereby
compressing precautionary saving and reducing consumption after retirement. However,
this option is available ex post only to long-term unemployed who …nd a new job; what
drives our results is the ex ante risk of permanently losing human capital.
Several papers already investigate alternative hypotheses that may explain the rela-
tively ‡at stock pro…le observed in the data that departs from the pattern implied by
traditional life-cycle models. Some of this prior research relates the resolution of uncer-
tainty over working life to the ‡attening of the age pro…le of stock investment. Hubener,
Maurer and Mitchell (2016) highlight the possibility of changing family status during
working age (i.e., marriage, fertility, divorce), which a¤ects consumption both directly
and through labour supply. In Bagliano, Fugazza and Nicodano (2014), such ‡attening
depends on the presence of both another risky asset, aside from equities, and a positive
correlation between stock returns and permanent labour income shocks. Moreover, the
‡attening only appears when risk aversion or the variance of labour income shocks are
higher than in the baseline calibration of Cocco Gomes and Maenhout (2005). Chang,
Hong and Karabarbounis (2017) show that realistic life-cycle pro…les of occupational un-
certainty and gradual learning about income volatility generate an age-increasing stock
investment pro…le.In our model, the ‡at pro…le is robust to an in-depth sensitivity analysis
and derives from the possibility of a rare personal labour market disaster, in an otherwise
standard baseline setting.
This disaster di¤ers from both the individual stock market disaster modelled in
Fagereng, Gottlieb and Guiso (2017) and the aggregate economic collapse explaining
asset pricing puzzles in Barro (2006). Both of these circumstances concern …nancial
wealth and may occur during retirement as well. The set-up here instead re‡ects the
rare idiosyncratic disaster in Schmidt (2016) that appears to capture both the magni-
tude and the dynamics of the equity risk premium. Such rare personal disaster makes

5
returns to human capital negatively skewed, a feature recently uncovered by Guvenen,
Karahan, Ozkan and Song (2015). Moreover, Huggett and Kaplan (2016) show that per-
sistency and negative skewness of earnings shocks reduce the value of human capital well
below the level implied by discounting earnings at the risk-free rate and increase its stock
component. In this light, our paper documents the large e¤ects of non-normal shocks
to labour income on life-cycle savings and investment, following the suggestion in Blun-
dell (2014) of capturing higher moments and nonlinearities in shocks to labour income.
Thus, our paper extends the literature on portfolio choice that has so far focused only on
non-Gaussian returns to …nancial assets (e.g., see Guidolin and Timmerman, 2008).
The rest of the paper is organized as follows. Section 2 presents the benchmark life-
cycle model and brie‡y outlines the numerical solution procedure adopted. We detail
the model calibration in Section 3 and discuss our main results in Section 4. Section 5
provides a quantitative assessment of the welfare loss entailed by departing from optimal
asset allocation pro…les and adopting conventional age-related investment rules. Several
robustness checks are presented in Section 6. Section 7 concludes the paper.

2 The life-cycle model

We model an investor who maximizes the expected discounted utility of consumption
over her entire life and wishes to leave a bequest as well. The investor starts working at
age t0 and retires with certainty at age t0 + K. The e¤ective length of her life, which lasts
at most T periods, is governed by age-dependent life expectancy. At each date t, the
survival probability of being alive at date t + 1 is pt , the conditional survival probability
at t (with pt0 1 = 1). Investor’s i preferences at date t are described by a time-separable
power utility function:
" j 2
! !#
Cit1 0 X
T Y Cit1 0 +j (Xit0 +j =b)1
j
+ Et0 pt0 +k pt0 +j 1 + (1 pt0 +j 1) b (1)
1 j=1 k=0
1 1

where Cit is the level of consumption at time t, Xit is the amount of wealth the investor
leaves as a bequest to her heirs after her death, b 0 is a parameter capturing the
strength of the bequest motive, < 1 is a utility discount factor, and is the constant
relative risk aversion parameter.

2.1 Labour and retirement income

During working life individuals receive exogenous stochastic earnings as compensation for
labour supplied inelastically. Working life careers are modelled as a three-state Markov

6
chain considering employment (e), short-term (u1 ) and long-term (u2 ) unemployment.
Individual labour market dynamics are driven by the following transition matrix:
0 1 0 1
ee eu1 eu2 ee 1 ee 0
B C B C
st ;st+1 =B
@ u1 e u1 u1 u1 u2
C=B
A @ u1 e 0 1 u1 e
C
A (2)
u2 e u2 u1 u2 u2 u2 e 0 1 u2 e

where nm = Prob (st+1 = njst = m) with n; m = e; u1 ; u2 . If the worker is employed

at t (st = e), she continues the employment spell at t + 1 (st+1 = e) with probability
ee , otherwise she enters short-term unemployment (st+1 = u1 ) with probability eu1 =
1 ee . Since she must experience short-term unemployment prior to becoming long-
term unemployed, we set the probability of directly entering long-term unemployment
at zero, eu2 = 0. Conditional on being short-term unemployed at t (st = u1 ), she
exits unemployment (st+1 = e) with probability u1 e or becomes long-term unemployed
(st+1 = u2 ) with probability u1 u2 =1 u1 e ; consequently, we set u1 u1 = 0. Finally,
if she is long-term unemployed at t (st = u2 ), she is re-employed in the following period
(st+1 = e) with probability u2 e and remains unemployed with probability u2 u2 =1 u2 e .

As in Cocco, Gomes and Maenhout (2005), the employed individual receives a stochas-
tic labour income driven by permanent and transitory shocks. In each working period,
labour income Yit is generated by the following process:

Yit = Hit Uit t0 t t0 + K (3)

where Hit = F (t; Zit ) Pit represents the permanent income component. In particular,
F (t; Zit ) Fit denotes the deterministic trend component that depends on age (t) and a
vector of individual characteristics (Zit ) such as gender, marital status, household com-
position and education. Consistent with the available empirical evidence, the logarithm
of the stochastic permanent component is assumed to follow a random walk process:

Nit = log Pit = log Pit 1 + ! it (4)

2
where ! it is distributed as N (0; ! ). Uit denotes the transitory stochastic component and
2
"it = log(Uit ) is distributed as N (0; ") and uncorrelated with ! it .
In our set-up, which di¤ers from that of Bremus and Kuzin (2014), labour income
received by the employed individual at time t depends on her past working history. In
particular, we allow unemployment and its duration to a¤ect the permanent component of
labour income, Hit . Since the empirical evidence suggests that the longer the unemploy-
ment spell the larger is the worker’s human capital depreciation (Schmieder, von Wachter

7
and Bender, 2016), we let human capital erosion increase with unemployment duration.
Thus, after 1-year unemployment the permanent component Hit is equal to Hit 1 eroded
by a fraction 1, and after a 2-year unemployment spell the permanent component, Hit 1 ,
is eroded by a fraction 2, with 2 > 1. This introduces non-linearity into the expected
permanent labour income. In compact form, the permanent component of labour income
Hit evolves according to
8
>
>F (t; Zit ) Pit if st = e and st =e
>
< 1

Hit = (1 1 )Hit 1 if st = e and st 1 = u1 t = t0 ; :::; t0 +K

>
>
>
:(1 )H2 it 1 if st = e and st 1 = u2 or if st = u2 and st 1 = u2
(5)
In the short-term unemployment state (st = u1 ) individuals receive an unemployment
bene…t as a …xed proportion 1 of the previous year permanent income Hit 1 = Fit 1 Pit 1 ,
whereas in the long-term unemployment state (st = u2 ) no bene…ts are available: 2 = 0.
Thus, the income received during unemployment is
8
< Hit 1 if st = u1 and st 1 =e
1
Yit = t = t0 ; :::; t0 + K (6)
:0 if st = u2

making the unconditional distribution of labour income no longer log-normal.

Finally, during retirement, income is certain and equal to a …xed proportion of the
permanent component of labour income in the last working year:

Yit = F t; Zit0+l Pit0+l t0 + K < t T (7)

where retirement age is t0 + K, t0 + l is the last working period and is level of the
replacement rate.

2.2 Investment opportunities

We allow savings to be invested in a short-term riskless asset, yielding a constant gross
real return Rf , and one risky asset, characterized as “stocks”yielding stochastic gross real
returns Rts , for each period. The excess returns of stocks over the riskless asset follows

Rts Rf = s
+ s
t (8)

s s
where is the expected stock premium and t is a normally distributed innovation,
2
with mean zero and variance s. We do not allow for excess return predictability and

8
other forms of changing investment opportunities over time, as in Michaelides and Zhang
(2017).
At the beginning of each period, …nancial resources available to the individual for
consumption and saving are given by the sum of accumulated …nancial wealth Wit and
current labour income Yit , which we call cash on hand Xit = Wit + Yit . Given the chosen
level of current consumption, Cit , next period cash on hand is given by

Xit+1 = (Xit Cit )RitP + Yit+1 (9)

where RitP is the investor’s portfolio return:

RitP = s s
it Rt + (1 s
it ) R
f
(10)

s s
with it and (1 it ) denoting the shares of the investor’s portfolio invested in stocks
and in the riskless asset respectively. We do not allow for short sales and we assume
that the investor is liquidity constrained. Consequently, the amounts invested in stocks
and in the riskless asset are non negative in all periods. All simulation results presented
below are derived under the assumption that the investor’s asset menu is the same during
working life and retirement.

2.3 Solving the life-cycle problem

In this intertemporal optimization framework, the investor maximizes the expected dis-
counted utility over life span, by choosing the consumption and the portfolio rules given
uncertain labour income and asset returns. Formally, the optimization problem is written
as:
" j 2
!
Cit1 0 X
T Y Cit1 0 +j
j
max + Et0 pt0 +k pt0 +j 1 +
fCit gT
t
1
;f sit g
T 1 1 j=1 k=0
1
0 t0
!#!
(Xit0 +j =b)1
+ (1 pt0 +j 1 ) b (11)
1

s s s f
s:t: Xit+1 = (Xit Cit ) it Rt + (1 it ) R + Yit+1 (12)

with the labour income and retirement processes speci…ed above and the no-short-sales
and borrowing constraints imposed. Given its intertemporal nature, the problem can
be restated in a recursive form, rewriting the value of the optimization problem at the
beginning of period t as a function of the maximized current utility and of the value of

9
the problem at t + 1 (Bellman equation):

Cit1
Vit (Xit; Pit ; sit ) = max + Et [pt Vit+1 (Xit+1; Pit+1 ; sit+1 )
fCit gT 1 s T
t0 ;f it gt
1 1
0
#!
(Xit+1 =b)1
+ (1 pt ) b (13)
1

At each time t the value function Vit describes the maximized value of the problem as
a function of three state variables: cash on hand at the beginning of time t (Xit ), the
stochastic permanent component of income at beginning of t (Pit ), and the labour market
state sit (= e; u1 ; u2 ). The Bellman equation can be written by making the expectation
over the employment state at t + 1 explicit:

Cit1
Vit (Xit; Pit ; sit ) = max
fCit gT 1 s T
t0 ;f it gt
1 1
0
2
X
+ 4pt g
(sit+1 jsit ) Et V it+1 (Xit+1; Pit+1 ; sit+1 )
sit+1 =e;u1 ;u2
31
X 1
(Xit+1 =b)
+ (1 pt ) b (sit+1 jsit ) 5A (14)
sit+1 =e;u1 ;u2
1

g
where Et V it+1 denotes the expectation operator taken with respect to the stochastic
s
variables ! it+1 ; "it+1 ; and it+1 . The history dependence that we introduce in our set-up
by making unemployment a¤ect subsequent labour income prospects prevents having to
rely on the standard normalization of the problem with respect to the level of Pt : To
highlight how the evolution of the permanent component of labour income depends on
previous individual labour market dynamics we write the value function at t in each
possible state as (dropping the term involving the bequest motive):

88
>
>>
<Vit+1 (Xit+1 ; Pit+1 ; e) with prob. e;e
>
>
>
> with Pit+1 = Pit e!it+1 and
>
>>
>
>: p "it+1
>
< Xit+1 = (Xit Cit )Rit + Fit+1 Pit+1 e
Vit (Xit ; Pit ; e) = u(Cit ) + pt
>
>8
>
>>
<Vit+1 (Xit+1 ; Pit+1 ; u1 ) with prob. 1
>
>
e;e
>
> with Pit+1 = (1
>
> 1 )Pit and
:>
>: p
Xit+1 = (Xit Cit )Rit + 1 Fit Pit

10
 88
>
>>
<Vit+1 (Xit+1 ; Pit+1 ; e) with prob. u1 ;e
>
>
>
> with Pit+1 = (1 ! it+1
= Pit e!it+1 and
> 1 )Pit 1 e
>
>>
:
>
> p "it+1
< Xit+1 = (Xit Cit )Rit + Fit 1 Pit+1 e
Vit (Xit ; Pit ; u1 ) = u(Cit )+ pt
>
> 8
>
> >
<Vit+1 (Xit+1 ; Pit+1 ; u2 ) with prob. 1
>
>
u1 ;e
>
> with Pit+1 = (1
>
>> 2 )(1 1 )Pit 1 = (1 2 )Pit and
>
::X p
it+1 = (Xit Cit )Rit
88
>
>>
<Vit+1 (Xit+1 ; Pit+1 ; e) with prob. u2 ;e
>
>
>
> !
with Pit+1 = Pit e it+1 and
>
>>
>
>:
> Xit+1 = (Xit Cit )Ritp + Fit 2 Pit+1 e"it+1
<
V (Xt ; Pt ; u2 ) = u(Ct ) + pt (15)
>
>8
>
>>
<Vit+1 (Xit+1 ; Pit+1 ; u2 ) with prob. 1
>
>
u2 ;e
>
> with Pit+1 = (1
>
> 2 )Pit and
:>
>:
Xit+1 = (Xit Cit )Ritp
This problem has no closed form solution; therefore, we obtain the optimal values
for consumption and portfolio shares, depending on the values of each state variable at
each point in time, by means of numerical techniques. To this aim, we apply a backward
induction procedure starting from the last possible period of life T and computing optimal
consumption and portfolio share policy rules for each possible value of the continuous state
variables (Xit and Pit ) by means of the standard grid search method.3 Going backwards,
for every period t = T 1; T 2; :::; t0 , we use the Bellman equation (14) to obtain
optimal rules for consumption and portfolio shares.

3 Calibration
Parameter calibration concerns investor’s preferences, the features of the labour income
process during working life and retirement, and the moments of the risky asset returns.
For reference, we initially solve the model by abstracting from the unemployment risk
as in Cocco, Gomes and Maenhout (2005). Then, we introduce unemployment risk and
consider two scenarios: (i) unemployment spells cause only temporary income losses, as
in Bremus and Kuzin (2014), and (ii) unemployment has permanent consequences on the
worker’s earnings ability.
Across all scenarios, the agent begins her working life at the age of 20 and works
for (a maximum of) 45 periods (K) before retiring at the age of 65. After retirement,
she can live for a maximum of 35 periods until the age of 100. In each period, we take
the conditional probability of being alive in the next period pt from the life expectancy
3
The problem is solved over a grid of values covering the space of both the state variables and the
controls in order to ensure that the obtained solution is a global optimum.

11
tables of the US National Center for Health Statistics. With regards to preferences, we
set the utility discount factor = 0:96, and the parameter capturing the strength of the
bequest motive b = 2:5 (which bears the interpretation of the number of years of her
descendants’consumption that the investor intends to save for). Finally, the benchmark
value for the coe¢ cient of relative risk aversion is = 5. The latter choice is relatively
standard in the literature (Gomes and Michaelides 2005; Gomes, Kotliko¤ and Viceira
2008) and captures an intermediate degree of risk aversion. However, Cocco, Gomes and
Maenhout (2005) and Bremus and Kuzin (2014) choose a value as high as 10 in their
benchmark setting. The riskless (constant) interest rate is set at 0:02, with an expected
s
equity premium …xed at 0:04. The standard deviation of the return innovations is set
at s = 0:157. Finally, we impose a zero correlation between stock return innovations
and aggregate permanent labour income disturbances ( sY = 0). Table 1 summarizes
the benchmark values of relevant parameters as well as their changes considered in our
subsequent analysis and robustness checks.

3.1 Labour income and unemployment risk

The labour income process is calibrated using the estimated parameters for US households
with high school education (but not a college degree) in Cocco, Gomes and Maenhout
(2005).
The share of long-term unemployment in total unemployment is fairly similar across
all education groups (Kroft, Lange, Notowidigdo and Katz, 2016). For instance, Mayer
(2014) observes that the percentage of unemployed workers who have been out of work for
2 years or more with a high school degree (12.8%) and with a bachelor’s degree (13.5%)
do not di¤er statistically. For the high school group, the variances of the permanent and
2 2
transitory shocks (! it and "it respectively) are equal to ! = 0:0106 and " = 0:0738.
After retirement, income is a constant proportion of the …nal (permanent) labour
income, with = 0:684 . The parameter values assumed above are maintained across all
scenarios.
The resulting labour income process does not capture the evidence in Krueger, Cramer
and Cho (2014) that the long-term unemployed experience a progressive declining re-
employability over time and are more likely to exit the labour force. We use data from
the Current Population Survey (CPS) to calibrate the transition probabilities from em-
ployment to unemployment to re‡ect the risk of entering unemployment along with the
observed average unemployment rates at di¤erent durations. According to the evidence
based on CPS reported in Kroft, Lange, Notowidigdo and Katz (2016), the annual tran-
4
For a more realistic Social Security System design and its implications on retirement, consumption
and investment decisions see Hubener, Maurer and Mitchell (2016).

12
sition probability from employment to unemployment is 4%. Given the duration depen-
dence and the steady decline in the annual out‡ow rate from unemployment to employ-
ment during the …rst year of unemployment (Kroft, Lange, Notowidigdo and Katz, 2016),
we set the probability of leaving unemployment after the …rst year at 85%. Our calibra-
tion appears quite conservative, since the chance of being employed 15 months later for
those who had been unemployed 27 weeks or more is only 36% (see the evidence on CPS
data in Krueger, Cramer and Cho, 2014).
The annual transition probabilities between labour market states are chosen to match
the average annual unemployment rate in the United States:
0 1
0:96 0:04 0
B C
st ;st+1 =B
@ 0:85 0 0:15 C
A (16)
0:85 0 0:15

The assumed transition matrix (16) yields quite conservative unconditional probabilities
of being short-run (3:8%) and long-run unemployed (0:6%), compared to the 2015 overall
(5.3%) and long-term (1.7%) unemployment rates.
In our baseline calibration with “unemployment traps” we assume a non-negligible
human capital depreciation following a 2-year unemployment spell. While 1 is kept at
0, 2 is increased up to 0:6, implying a 60% erosion of the individual permanent labour in-
come component after the second year of unemployment, which captures the long-lasting
e¤ects of protracted inactivity on job careers. Well-established empirical evidence on job
displacement shows that job losses a¤ect earnings far beyond the unemployment spell,
though the range of the estimated e¤ects varies considerably. For example, the estimates
for immediate losses following displacement may range from 30% (Couch and Placzek,
2010) to 40% of earnings (Jacobson, Lalond and Sullivan, 1993b). Earnings losses are
shown to be persistent in a range from 15% (Couch and Placzek, 2010) to about 25%
(Jacobson, LaLonde and Sullivan, 1993a) of their pre-displacement levels. These esti-
mates abstract from the e¤ect of unemployment duration, while Cooper (2013) …nds that
earnings losses are larger the longer unemployment lasts. Also, based on administrative
data, Jacobson, LaLonde and Sullivan (2005) estimate that average earnings losses for
displaced workers amount to 43-66% of their predisplacement wage. This body of evi-
dence, combined with a probability of …nding a job after being unemployed for 24 months
as low as 40% (Kroft, Lange, Notowidigdo and Katz, 2016), leads us to calibrate a sub-
stantial expected drop in human capital following a long term unemployment spell. More
precisely, we derive the baseline value for the parameter 2 by considering the probability
of leaving the labour force, and thus losing all human capital, as equal to 0:3 and the
probability of …nding a new job with a 40% cut in wage as 0:7:

13
 Unemployment bene…ts are calibrated according to the US unemployment insurance
system. In particular, considering that the replacement rate with respect to last labour
income is on average low and state bene…ts are paid for a maximum of 26 weeks, we set
1 = 0:3 in case of short-term unemployment spells and set a value of 2 = 0 for the
long-term unemployed. No additional weeks of federal bene…ts are available in any state:
the temporary Emergency Unemployment Compensation (EUC) program expired at the
end of 2013, and no state currently quali…es to o¤er more weeks under the permanent
Extended Bene…ts (EB) program.5
For comparison, we also consider a calibration of the model without unemployment
risk. This “no unemployment risk”scenario corresponds to the standard life-cycle set up
with ee = 1 and all other entries equal to zero in the transition probability matrix (2). In
addition, to highlight the e¤ects of permanent consequences of unemployment on future
earnings prospects, we consider a third calibration by adding the unemployment risk
embedded in the transition probability matrix (16) with no human capital erosion. In this
“unemployment with no traps”scenario, unemployment has no permanent consequences
on future earnings (i.e. 1 = 2 = 0) but entails only a cut in current income. This case
closely corresponds to the set-up studied by Bremus and Kuzin (2014), who focus only
on temporary e¤ects of long-term unemployment.

4 Results

4.1 Optimal policies

Figure 1 compares investors’optimal stock shares in the standard case of “no unemploy-
ment risk” (panel (a)) and in our preferred scenario with “unemployment traps” (panel
(b)). In particular, the …gure plots the optimal stock share as a function of cash on hand
for an average level of the permanent labour income component of investors at three dif-
ferent ages (20, 40, and 70). In the case with no unemployment risk, standard life-cycle
results are obtained. Labour income acts as an implicit risk-free asset and a¤ects the
optimal portfolio composition depending on an investor’s age and wealth. For exam-
ple, at age 20 the sizable implicit holding of the risk-free asset (through human capital)
makes it optimal for less-wealthy investors to tilt their portfolio towards the risky …nan-
cial asset. Indeed, for a wide range of wealth levels, agents optimally choose to be fully
invested in stocks. The optimal stock holding decreases with …nancial wealth because of
5
Low, Meghir and Pistaferri (2010) acknowledge that layo¤s are partially insured by the unemploy-
ment insurance system, while individual productivity shocks, other than major observable health shocks,
are rarely insured in any formal way. As for other welfare programs, we do not model basic consumption
needs and therefore overlook basic consumption insurance.

14
the relatively lower implicit investment in (risk-free) human capital.
When the model is extended to allow for permanent e¤ects of unemployment spells on
labour income prospects at re-employment (“unemployment traps”), with the parameters
governing the proportional erosion of permanent labour income set at 1 = 0 after one
year of unemployment and at 2 = 0:6 after 2 years, the resulting policy functions are
shifted abruptly leftward. The optimal stock share still declines with …nancial wealth but
a 100% share of investment in stocks is optimal only at very low levels of wealth. In this
case, long-term unemployment implies the loss of a substantial portion of future labour
income which severely reduces the level of human capital and increases its risk at any
age. Thus, for almost all levels of …nancial wealth, stock investment is considerably lower
than in the case of no unemployment risk.

4.2 Life-Cycle Pro…les

On the basis of the optimal policy functions, we simulate the whole life-cycle consump-
tion and investment decisions for 10,000 agents. Figure 2, panel (a), shows the average
optimal stock shares plotted against age when unemployment risk is ignored and when
it is accounted for. In the case of no unemployment risk (dotted line), the well-known
result on the age pro…le of optimal stock portfolio shares is obtained. Over the life cycle
the proportion of overall wealth implicitly invested in the riskless asset through human
capital declines with age. Consequently, at early stages of the life cycle, optimal stock
investment is about 100% and decreases with age to reach around 80% at retirement.
When unemployment risk without human capital erosion is considered (dashed line), the
optimal portfolio share of stocks still declines with age, though being slightly lower at all
ages, with a 100% optimal stock share only for very young investors.
However, when long-term unemployment implies a rare but large skill erosion (solid
line), the optimal stock investment is sizably reduced at any age and almost ‡at, at
around 55-60%. The risk of permanently losing a substantial portion of future labour
income prospects reduces the level of human capital and increases its riskiness. Because
this e¤ect is particularly relevant for younger workers, it induces a lower optimal stock
investment conditional on …nancial wealth especially when young. Consequently, the age
pro…le remains remarkably ‡at over the whole working life.6 These results highlight that
possible long-run consequences of unemployment signi…cantly dampen the incentive to
invest in stocks, under standard calibrations, whereas unemployment persistence, with
only temporary income losses as in Bremus and Kuzin (2014), has almost no e¤ect on
the age pro…le of optimal portfolio composition.
6
The relatively low investment in stocks during retirement is due to the presence of a positive bequest
motive, common to all parametrizations considered in this paper.

15
 The reduction in the optimal portfolio share allocated to stocks is due to higher wealth
accumulation, in turn induced by larger precautionary savings.7 Panel (b) of Figure 2
displays the average …nancial wealth accumulated over the life cycle for the three scenarios
considered. In the face of possible, albeit rare, human capital depreciation, individuals
accumulate substantially more …nancial wealth during working life to bu¤er possible
disastrous labour market outcomes. Optimal consumption when young consequently
falls, but it is much higher during both late working years and retirement years. Figure 3
displays the life-cycle pro…le of the ratio between savings and total (…nancial plus labour)
income, comparing the case without unemployment risk to the one with unemployment
traps. When the worker is 20 years old, the average propensity to save is especially high
in the latter case, reaching 0:8 compared with less than 0:2 when unemployment risk is
absent. Such propensity monotonically decreases in age, converging to the known pattern
when the worker is in her forties. The …gure clearly depicts the impact on savings of the
resolution of uncertainty as individuals age.
Consistent with these predictions, data on Norwegian households show that they
engage in additional saving and in shifting toward safe assets in the years prior to un-
employment, as well as in depletion of savings after the job loss (see Basten, Fagereng
and Telle, 2016). Importantly, our results imply that labour market institutions targeted
to long-term unemployment a¤ect both risk taking in the equity market and precau-
tionary saving. The expectation of a higher bene…t may mitigate the adverse impact of
long term unemployment on human capital, reducing the need for cautious investing and
saving during working life. The variation of institutions across countries may thus gen-
erate di¤erent life-cycle patterns in equity investing. In this light, the decreasing stock
holdings in Norwegian data (appearing in Fagereng, Gottlieb and Guiso, 2017) may be a
consequence of higher long-term unemployment bene…ts with respect to the US.

4.2.1 Heterogeneity

The above results imply that the optimal stock investment is ‡at in age, even for a mod-
erately risk averse worker. In the face of a very rare but large human capital depreciation,
workers on average invest about 55% of their …nancial wealth in stocks. This average
pattern may hide considerable di¤erences across agents. The present section investigates
the distribution across agents of both conditional optimal stock share and accumulated
wealth.
The case of no unemployment risk is displayed in panels (a) and (b) of Figure 4, which
7
Love (2006) shows that higher unemployment insurance bene…ts reduce calibrated contributions to
pension funds by the young, suggesting that precautionary savings when young is due to unemployment
risk.

16
show the 25th , 50th and 75th percentiles of the distributions. Both the optimal stock share
and the stock of accumulated …nancial wealth are highly heterogeneous across workers
as well as retirees. The exception is young workers as they tilt their entire portfolio
towards stocks given the relatively riskless nature of their human capital. Heterogeneity of
portfolio shares depends on the shape and movements through age of the policy functions
displayed in Figure 1, relating optimal stock shares to the amount of available cash on
hand, and on the level of cash on hand itself. Relatively steep policy functions imply that
even small di¤erences in the level of accumulated wealth result in remarkably di¤erent
asset allocation choices. At the early stage of the life cycle, when accumulated …nancial
wealth is modest, it is optimal for everybody to be fully invested in stocks. As investors
grow older, di¤erent realizations of background risk induce large di¤erences in savings
and wealth accumulation. This situation pushes investors on the steeper portion of their
policy functions and determines a gradual increase in the heterogeneity of optimal risky
portfolio shares during their working life. After retirement, investors decumulate their
…nancial wealth relatively slowly, due to the bequest motive, and still move along the
steeper portion of their relevant policy functions; as a consequence, the dispersion of
optimal shares tends to persist.
Panels (c) and (d) of Figure 4 display the life-cycle distribution of stock share and
…nancial wealth for the case with unemployment risk and human capital erosion. Com-
pared with the case of no unemployment risk, the distribution of optimal stock shares
is much less heterogeneous over the whole life cycle. In particular, heterogeneity shrinks
during working life even for young workers, given the high human capital risk they bear
at the beginning of their careers. In case of unemployment risk, policy functions are
relatively ‡at (see panel (b) of Figure 1) implying that even large di¤erences in the level
of accumulated wealth result in homogenous asset allocation choices. Then, as in the pre-
vious case, the shape of heterogeneity of stock shares and accumulated …nancial wealth
over the life cycle is due to di¤erent realizations of background risk.

5 Welfare analysis of suboptimal choices

Workers usually delegate the task of managing long-term saving on their behalf to their
pension funds. The strategies proposed by portfolio managers often embed the feature of
a decreasing age pro…le of investment in the riskier assets, with a portfolio share in stocks
often in excess of 80% when young. These strategies resemble the ones that are optimal
in the absence of unemployment risk. In fact, Cocco, Gomes and Maenhout (2005) …nd
that the representative worker should enjoy only a slightly higher (0.64%) consumption
level to be compensated for the adoption of a suboptimal "age rule" by her pension fund.

17
Bagliano, Fugazza and Nicodano (2014) …nd that a compensation of a similar amount
is needed when the investor’s asset menu also includes bonds, unless stock returns and
permanent income shocks are positively correlated.8 Love (2013) …nds even lower welfare
losses when optimizing over the parameters of the rule of thumb.
This section provides a quantitative assessment of the welfare loss associated with the
adoption of simple portfolio allocation rules of thumb related to age when there are rare
unemployment traps. We also explore an alternative suboptimal situation, in which there
are unemployment traps but the worker adopts the utility-maximizing consumption and
portfolio allocation that ignores them.9 This case is inspired by the scant discussion of
long-term unemployment in the United States prior to the recent crisis, which implies
underestimation of the problem before 2007. The crisis may have generated a structural
break in the economy, aggravating the long-term unemployment problem or it may have
enhanced the awareness of the rare occurrence of unemployment traps. The analysis of
this case also delivers an upper bound to the welfare gains achievable when workers switch
to the optimal asset allocation, taking into account the potential occurrence of long-term
unemployment spells with permanent consequences on their earnings prospects.
In particular, we consider two suboptimal asset allocation patterns related to the
investor’s age. The …rst is the typical "age rule" analysed by Cocco, Gomes and Maenhout
(2005), with a risky portfolio share set at 100 less the investor’s age.10 The second rule of
thumb, denoted as “target-date fund (TDF) rule”, comes closer to actual strategic asset
allocation patterns adopted by Target-Date Funds. As shown in panel (a) of Figure 5,
the stock portfolio share is set at 90% until the age of 40, is gradually decreased over
the remaining working life down to 50% at retirement age (65), and further reduced
in the early retirement period to reach a low of 30% at the age of 72. This TDF rule
echoes the one investigated by Bagliano, Fugazza and Nicodano (2014) with the investor’s
asset menu also including bonds. In both cases considered above, the worker is aware
of unemployment traps and optimally chooses saving and consumption given the rule-
of-thumb portfolio allocation. Our welfare analysis concludes with the suboptimal case
when the worker maximizes expected utility oblivious of rare personal disasters.
The metric used to perform welfare comparisons is the standard consumption-equivalent
variation employed by Cocco, Gomes and Maenhout (2005). The consumption-equivalent
variation is obtained by simulating optimal consumption and wealth accumulation choices
8
Only in the case of positive correlation is the compensating consumption higher; it may reach 3.9%
for the benchmark risk aversion parameter ( = 5).
9
In all the three subotptimal cases, the underlying labour income process is the one implied by the
presence of unemployment traps.
10
In a variant of this “age rule”, the worker starts saving for retirement 40 years before the target
retirement date, setting the initial share of stocks at 80% and letting it fall to 40% at retirement (Bodie,
Treussard and Willen, 2007).

18
conditional on following the optimal asset allocation strategy and each of the alternative
(suboptimal) investment rules and by deriving the associated expected discounted lifetime
utility levels. By inverting the derived expected discounted lifetime utility, we compute
the constant consumption stream needed to compensate the investor for the adoption of
suboptimal strategies. We then compute the percentage increase in annual consumption
required by the investor to obtain the same level of expected utility warranted by the
optimal life-cycle strategy for each suboptimal rule. Throughout our comparisons, we
adopt the benchmark calibration parameters reported in Table 1.

5.1 Results
The left-hand side of Table 2 shows the welfare gains associated with switching from the
"age rule" to the optimal portfolio choice. Both the mean and the median increases in
welfare-equivalent consumption are equal to 3.3%. Welfare gains are three times larger
than prior estimates in the literature. Such gains derive from the fact that consumption
and savings are distorted by the higher risk taking when the worker faces a large amount
of uncertainty about future labour and pension income, as well as by the lower risk taking
when uncertainty is resolved. Average consumption (panel (b) of Figure 5) is close to
the optimal level during early working years under the "age rule", but it is much lower
during retirement. Moreover, as shown in panel (c), while wealth accumulation until age
55 is close to optimal, average …nancial wealth at retirement and thereafter turns out to
be lower under the "age rule". This pattern is due to agents who, having incurred a trap,
save less and ultimately - given the quick reallocation towards the riskless asset - are
also able to consume and bequeath less. Those workers who do not experience personal
disasters are able to set aside more wealth, but gradual conversion into the riskless asset
reduces the return on the …nancial wealth relative to investors adopting optimal portfolio
shares. The pattern of welfare gains across income brackets is surprising, however, as
revealed by panel (b) of Table 2. Mean welfare gains when income at age 64 is below
the 5th percentile of income distribution are lower than for agents with income above
the 95th percentile (1.6% versus 2.4%). We tentatively ascribe such a result to the fact
that a distorted portfolio rule delivers lower utility losses at the bottom of the income
distribution because of lower …nancial wealth.
The middle column of Table 2 displays welfare gains when the investor adopts the
optimal asset allocation pattern instead of the TDF rule, with the stock portfolio share
exceeding the one dictated by the "age rule" until age 55 and later falling below it. Given
that higher exposure to …nancial risk is present early in life and lower exposure during
retirement, mean and median welfare gains from adopting the optimal portfolio rule
are much higher (above 10% of yearly consumption). This pattern emerges despite two

19
seeming improvements, highlighted in Figure 5. The …rst is that mean consumption under
a TDF portfolio allocation is higher from age 30 until age 80 than consumption under
the optimal portfolio rule. The second is that mean …nancial wealth exceeds the optimal
one until the investor is past age 80. The increased consumption during working life and
early retirement is thus more than o¤set by the marked reduction during later retirement
years, followed by a lower bequest. Once again, the mean welfare gains are lower for those
with income (at age 64) below the 5th percentile of income distribution than for those
with income above the 95th percentile (9.5% versus 12.3%). Both experiments suggest
that distortions in asset allocation produce larger welfare losses for richer households.
The right-hand column of Table 2 delivers an upper bound on median welfare gains
from becoming aware of unemployment traps (more than 200%). Mean welfare gains are
even higher (642%). This pattern derives from a much higher average consumption until
age 40, leading to lower bu¤er savings, for the unaware worker who chooses consumption
and portfolios composition as in Cocco, Gomes and Maenhout (2005) (see panel (b) in
Figure 5). If a long-term unemployment spell occurs, consumption and bequest drop
dramatically, in some cases almost to zero. This drop implies a large utility loss for
a tiny share of workers, causing a sizable increase in mean welfare loss relative to the
median value. Since close-to-zero consumption is likelier at the bottom of the income
distribution, mean welfare gains from becoming aware of traps are higher for those with
low rather than high income, at age 64 (1024% against 218% as shown in panel (b) of
Table 2). Figure 6 con…rms the above interpretation, displaying mean income pro…les for
individuals conditional on welfare gains. Workers with lifetime earnings above the mean
obtain welfare gains below the 5th percentiles. In turn, workers enjoying the largest
welfare gains are those with lifetime labour income well below the average. Clearly,
the earlier the traps occur, the lower the bu¤er wealth and the worse the consumption
and welfare consequences. The latter observation hints at a welfare-improving scheme
designed to support the fraction of workers hit by long-term unemployment when young,
along the lines suggested by Michelacci and Ru¤o (2015). More generally, the size of
the welfare losses suggests to move towards schemes that protect against longer-term
unemployment (e.g., see Setty 2017).

6 Robustness and Other Challenges

This section sheds additional light on the strength of our results, that radically depart
from the accepted wisdom concerning optimal life-cycle behaviour during working years
and hold across the entire distribution of investors.
A …rst robustness check concerns the sensitivity of our results to a lower probability

20
of personal disaster. In performing such analysis, we also allow for an asymmetric
reduction in the probability of long-term unemployment with respect to workers’ age.
Recent data from US labour market statistics indeed show that the composition of long-
term unemployment is shifting towards the elderly. In 2015 the overall and the long-term
unemployment rates in US were about 5.7% and 1.7%, respectively, with the share of
long-term unemployment in the overall unemployment rate di¤ering widely among age
groups: from 20% among young workers (16-24 years old), to 35% among prime age
workers (25-55), and up to 41% among older workers (over 55).
A second check regards the modelling of the link between unemployment risk during
working life and retirement income, so as to make sure that our results do not originate
exclusively from long-term unemployment occurring during the very last working years,
which heavily reduces retirement income.
Further, since the power utility function implies that the worker is indi¤erent to
intertemporal correlation of consumption shocks (e.g., see Bommier, 2007), we adopt
Epstein-Zin preferences to investigate whether positive correlation aversion boosts the
impact of unemployment traps. A similar motivation leads us to analyse the sensitivity
of the equity-investment pro…le to positive correlation between stock returns and labour
income shocks.
Importantly, we experiment with more conservative calibrations and alternative mod-
elling of human capital erosion, so as to represent the possibility of incurring in large
losses only in deep crisis situations rather than in normal business cycle downturns.
Finally, we address some logical challenges relating to our analysis, including its gen-
eral equilibrium implications.

6.1 Age-dependent unemployment risk

In this section, we calibrate our model with unemployment traps, allowing for both
a smaller and age-dependent long-term unemployment risk. We change the transition
probability from short-term to long-term unemployment, denoted as u1 u2 in the following
transition probabilities matrix:
0 1
0:96 0:04 0
B C
st ;st+1 =B
@ 1 u1 u2 0 u1 u2
C
A
0:85 0 0:15

with respect to the baseline calibration in (16) where u 1 u2 = 0:15 irrespective of the
worker’s age. In “case 1 ”, the probability of entering long-term unemployment is re-
duced by one third (from 0:15 to 0:10) only for workers younger than 50 years old. In

21
“case 2 ”, we further reduce the probability of entering long-term unemployment for very
young workers, setting u1 u2 = 0:075 for workers less than 30 years old. In all sce-
narios, transition probabilities are rather conservative implying steady-state long-term
unemployment rates lower than the actual one. For reference, in the baseline case, the
steady-state long-term unemployment rate is 0:6%, while it is 0:5% and 0:4%, in cases 1
and 2, respectively.
Figure 7 reports the life-cycle pro…les for the optimal conditional stock holding and
…nancial wealth accumulation when the long-term unemployment risk is age-dependent.
Compared with the baseline case, the age pro…le of stock investment is only slightly
modi…ed. A lower long-term unemployment risk at young ages implies a moderately
higher stock share during prime age but it does not signi…cantly alter investors’behaviour
later over the working life and during retirement. In addition, it has virtually no e¤ect
on wealth accumulation.

6.2 Unemployment risk and retirement income

In our model, pension bene…ts are a …xed proportion of the last labour income earned
prior to retirement age. Such income is especially sensitive to human capital loss due
to the occurrence of long-term unemployment in years just before retirement. Thus, we
analyse whether our results are robust to changes in modelling the link between long-term
unemployment at old ages and subsequent pension provisions.
To begin with, we assume no human capital loss in the event that unemployment
occurs in the years immediately before retirement. Our simulation results show that the
‡attening of the optimal stock share pro…le carries over to this setting, suggesting that
it is not an artifact of how we model pension income. In a second check, we take the
solution of our original model (calibrated in the case of unemployment risk with human
capital erosion) and focus on simulated life-cycle pro…les for two selected groups of agents.
The …rst group includes workers who have experienced just one long-term unemployment
spell of 5 years over the entire working life at the beginning of their job career (i.e., before
the age of 35), whereas the other group contains workers who have experienced just one
long-term unemployment spell of 5 years over their entire working life but at the end
of their career (i.e., after the age of 60). We …nd that in both cases, average life-cycle
stock share pro…les exhibit the ‡attening property. This experiment con…rms that the
‡attening is due to the riskier nature of human capital, together with the resolution of
uncertainty during working age, and it is not a¤ected by speci…c assumptions on the
determinants of pension income.

22
6.3 Boosting the e¤ect of unemployment traps
In this section, we consider two possible avenues that might reinforce our results. The
…rst one is to allow for a positive correlation between stock return innovations and the
innovations in permanent labour income ( sY > 0 ), on top of human capital erosion.
Results in Bagliano, Fugazza and Nicodano (2014) show that a realistically small corre-
lation has large e¤ects on life-cycle choices when it interacts with a higher variance of the
permanent component of labour income shocks. One may therefore expect a similar e¤ect
in the presence of unemployment traps. Empirical estimates of the stock return-labour
income correlation di¤er widely, even when we restrict the scope to the US economy.
Cocco, Gomes and Maenhout (2005) report estimated values not signi…cantly di¤erent
from zero across various education groups, in line with Heaton and Lucas (2000), whose
estimates range from -0.07 to 0.14 . However, Campbell, Cocco, Gomes and Maenhout
(2001) …nd higher values, ranging from 0.33 for households with no high school education
to 0.52 for college graduates. In the simulations below, we adopt an intermediate positive
value of sY = 0:2.
Figure 8 shows optimal portfolio shares of stocks and the pattern of …nancial wealth
accumulation with no correlation and with a positive correlation between labour income
shocks and stock returns. While the shape of life-cycle pro…les is relatively una¤ected,
the average stock share is lower at all ages. In case of positive correlation, labour income
is closer to an implicit holding of stocks, reducing the incentive to invest in stocks at
all ages. More speci…cally, in comparison with the case of no correlation, such investors
are relatively more exposed to stock market risk and will prefer to o¤set such risk by
holding a lower fraction of their …nancial portfolio in stocks. The stock share remains
substantially ‡at over the whole working life, displaying limited variability around a level
of about 50%. At the retirement age of 65, human capital becomes riskless since pension
income is certain and therefore uncorrelated with stock return innovations. Thus investors
rebalance their portfolio towards stocks: during retirement, the level and time pro…le of
the stock share are very close to the case of no correlation. Further, the relative increase
in human capital risk due to a positive correlation does not substantially alter the pattern
of …nancial wealth accumulation.
The second experiment implements a change in preferences that allows for intertem-
poral correlation aversion (Bommier, 2007). With a power utility function, the worker
is indi¤erent to positive or negative intertemporal correlation of consumption (shocks).
With Epstein-Zin preferences, the worker is averse to positive correlation when the coe¢ -
cient of relative risk aversion is greater than the inverse of the elasticity of intertemporal
substitution (EIS). Adopting a recursive (Epstein-Zin) formulation for preferences and
keeping the risk aversion parameter constant ( sY = 0:2), we simulate the model with

23
positive (EIS=0.5) and negative (EIS=0.1) correlation aversion, comparing the results
with our baseline case of indi¤erence (i.e., power utility, EIS=0.2). Figure 9 shows that
aversion to positive correlation has a negligible e¤ect during working years, while it causes
a slower wealth decumulation and less risk taking during the retirement period, especially
as death approaches. This …nding is consistent with the known property that higher mor-
tality risk magni…es the e¤ects of intertemporal correlation aversion (Bommier, 2013).
Overall, the preceding experiments con…rm the robustness of the ‡attening of the
life-cycle pro…le to changes in both hedging opportunities in the stock market and to
the intertemporal elasticity of substitution, pointing to the dominance of the personal
disaster e¤ect.

6.4 Sensitivity to human capital erosion

We now check the sensitivity of life-cycle pro…les with respect to the magnitude of the
human capital erosion e¤ect due to long-term unemployment, captured by the parameter
2 (set equal to 0:6 in our baseline calibration). Since, as discussed in Section 3, available
estimates of earnings losses due to long-term unemployment are as low as 15% of the
level of pre-displacement earnings, Figure 10 shows the results of an experiment with
the human capital erosion parameter 2 in the range 0:2 0:6. Once this parameter
falls to 0:4; the hump shape in the portfolio share of stocks appears again over working
life. The life-cycle pro…les of both the optimal risky portfolio share and …nancial wealth
accumulation track closely in the case of no unemployment when the potential human
capital loss is equal to 20%.
So far, the human capital erosion parameters 1 and 2 are set equal to constants.
However, they could more appropriately be modelled as stochastic variables. After all,
the tragic human capital consequences of the unemployment trap emerged in the United
States during the Great Recession, but were less evident in the past. This outcome may
correspond to high (low) realizations of 2 for a large number of workers in the Great
Recession (business cycle expansions) and an intermediate value in ordinary business
cycle contractions.
The Beta distribution can be usefully employed to model the behaviour of random
variables that take values limited to …nite intervals. In the current case, random vari-
ables j (j = 1; 2) are fractions limited to the interval [0; 1]. We therefore assume
that j follow Beta distributions with support [0; 1] and shape parameters (aj ; bj ): thus,
j Beta(aj ; bj ). The ‡exibility of the distribution allows us to concentrate nearly all
the probability mass towards the most probable values of proportional human capital
erosion, leaving the possibility of extremely unlikely realizations open. The most reveal-
ing case is displayed in Figure 11. While 1 is kept at 0, 2 follows the Beta distribution

24
with expected value ranging between 0:10 and 0:20 and standard deviation between 0:21
and 0:32, implying an expected 10% 20% erosion of the individual permanent labour in-
come component after the second year of unemployment. More precisely, the calibrated
distribution for 2 implies a median value for the proportional human capital erosion
lower than 1%, while the 75th percentile ranges between 6% and 25%. It turns out that
under all distributional assumptions, life cycle pro…les are very similar to the case of the
benchmark value of 2 = 0:6.
This outcome provides a …nal indication that extremely rare but potentially disastrous
labour income shocks may be relevant to understand cautiousness by young workers and
their limited risk taking in the stock market.

6.5 Additional challenges

Positive work on life-cycle consumption and saving shows how to calibrate all the key pa-
rameters to match the empirical evidence. On the one hand, considering a su¢ ciently high
subjective discount factor prevents households from accumulating an excessive amount of
wealth. It also reduces the stock market participation cost needed to match the observed
non-participation patterns at a realistic level (e.g., see Fagereng, Gottlieb and Guiso,
2017). On the other hand, the introduction of subsistence consumption levels avoids
counterfactually high saving rates, especially early in life when individuals are more likely
to be liquidity constrained (see e.g. Hubbard, Skinner and Zeldes, 1995; DeNardi, French
and Jones, 2010). While these patterns obtain in our model in unreported calibrations,
this paper focuses, instead, on the normative implications of long-term unemployment
risk for conditional optimal stock holdings.
Even though we do not attempt to explicitly compare our results to data on portfolio
choice, our set-up generates a more empirically plausible life-cycle pro…le of portfolio
choice with respect to models that abstract from possible permanent losses following
long-term unemployment. In our calibrations, we focus on income pro…les of workers
with a high school education. Our results also apply to college-educated workers given
that the long-term unemployment risk uniformly a¤ects both high school and college-
educated individuals (e.g., see Mayer, 2014).
The paper focuses on long-term unemployment risk as a source of rare personal disas-
ter during working life. However, individuals face various additional sources of potential
disaster (illness, accidents, personal bankruptcy, etc.) that may lead to substantial human
capital loss, which would reinforce our results on optimal risk taking.
Finally, our model obtains the optimal reduction in stock holdings over working life
in partial equilibrium. The combination of individuals’ life cycle saving behaviour and
population age structure in an overlapping generation framework may reinforce our results

25
through asset pricing (e.g., see Poterba, 2001). A relatively large middle-age cohort
depresses expected stock returns, strengthening the reduction in optimal risk taking by
the younger generation in response to long-term unemployment risk.

7 Conclusions
As the recent Great Recession episode has highlighted, long-term unemployment spells
may persistently damage workers’human capital. Against this backdrop, this paper in-
vestigates the e¤ects of unemployment traps on life-cycle savings and portfolio choice, in-
troducing higher moments and non-linearities in the labour income process. This method-
ological innovation enables new insights. Even a small probability of experiencing human
capital erosion due to long-term unemployment can generate optimal conditional stock
shares more in line with those observed in the data. Because of the possibility of human
capital loss, young workers face higher uncertainty concerning future income and social
security pension levels than older workers. At the same time, young workers with con-
tinuous careers have larger human capital than older workers. When a highly unlikely
unemployment spell may potentially lead to considerable human capital erosion, the …rst
e¤ect o¤sets the second and the optimal investment in stocks is relatively ‡at over the life
cycle. This result departs from the implications of previous models, with linear income
shocks highlighting the importance of unemployment traps for the life-cycle portfolios.
Our calibrations also suggest an alternative, more balanced design for target-date
investment funds. Such modi…ed design implies an average 3% -10% increase in welfare-
equivalent annual consumption, depending on the benchmark "age rule". This more
balanced design …ts di¤erent kinds of workers, given the limited heterogeneity in life-
cycle investments induced by the threat of personal disasters. More generally, our analysis
indicates that the pattern of risk taking at di¤erent ages in Target Date Funds should be
related to the share of uninsured long-term employment risk.
Our analysis implies that changes should be observed in the life-cycle pro…le of house-
hold portfolios, both across cohorts and across countries, in response to the coverage of
long-term unemployment. Clearly there are other sources of human capital erosion, as
well as other partial insurance vehicles. The optimal ‡at asset allocation will extend to
such scenarios to the degree that such additional shocks remain partially uninsured by
additional hedges and that they have worse consequences the earlier they hit the worker.

26
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29
Table 1: Calibration parameters
This table reports benchmark values of relevant parameters.

Description Parameter Value

Working life (max) T 20 -65
Retirement (max) t0 + K 65 -100
Discount factor (β) 0.96
Risk aversion (γ) 5
Replacement ratio (λ) 0.68
Variance of permanent shocks to labour income (σω2 ) 0.0106
Variance of transitory shocks to labour income (σ2 ) 0.0738
Riskless rate (r) 2%
Excess returns on stocks (µs ) 4%
Variance of stock returns innovations (σs2 ) 0.025
Stock ret./permanent lab. income shock correlation (ρsY ) 0

No unemployment risk Unemployment Unemployment traps

with no traps
Unemployment benefits
Short-term unemployed (ξ1 ) - 0.3 0.3
Long-term unemployed (ξ2 ) - 0 0

Human capital erosion

Short-term unemployed (Ψ1 ) - - 0
Long-term unemployed (Ψ2 ) - - 0.6

Table 2: Welfare Gains

This table reports welfare gains (in percentage points) due to the adoption of optimal choices instead of suboptimal
ones. The first and second columns display gains from abandoning suboptimal “Age Rule” and “Target Date
Fund Rule ” for asset allocation. The third column refers to gains deriving from taking account of unemployment
traps in the optimization process with respect to being unaware of traps. Panel (a) displays the distribution of
welfare gains. Panel (b) compares mean gains for workers, at age 64, with income below the 5th percentile and
above the 95th percentile of income distribution.

Age Rule TDF rule Unaware of Traps

(a) Distribution of welfare gains (% points)

Mean 3.3 12.0 642.5
Median 3.3 11.8 215.8
5th 1.5 8.0 -40.5
95th 5.4 17.0 573.6

(b) Welfare gains conditional on income at age 64 (% points)

Below 5th percentile 1.6 9.5 1024.0
Above 95th percentile 2.4 12.3 218.2

30
Figure 1: Policy functions
This figure shows the portfolio rules for stocks as a function of cash on hand for an average level of the stochastic
permanent labor income component. The policies refer to selected ages: 20, 40, and 70. Panel (a) and (b)
refer respectively to the cases with no unemployment risk and with unemployment traps. In the latter case,
the parameters governing the human capital erosion during short-term and long-term unemployment spells are
Ψ1 = 0 and Ψ2 = 0.6. Cash on hand is expressed in ten thousands of U.S. dollars.

(a) No unemployment risk

(b) Unemployment traps

31
Figure 2: Life-cycle average profiles
This figure displays the mean simulated stock investment and financial wealth accumulation life-cycle profiles.
Age ranges from 20 to 100. The three cases correspond to no unemployment risk (dotted line); unemployment
risk with no traps (dashed line); unemployment risk with traps (solid line). In the latter case, the parameters
governing the human capital erosion during short-term and long-term unemployment spells are Ψ1 = 0 and
Ψ2 = 0.6. Financial wealth is expressed in ten thousands of U.S. dollars.

(a) (b)

Figure 3: Life-cycle profiles of savings rate

This figure displays the savings dynamics for individuals of age 20 to 100, relative to total income (i.e. labor in-
come plus financial income). The two cases correspond to no unemployment risk (dotted line) and unemployment
risk with traps with human capital erosion: Ψ1 = 0 and Ψ2 = 0.6 (solid line).

32
Figure 4: Life-cycle percentile profiles
This figure displays the distribution of simulated stock investment and financial wealth accumulation life-cycle
profiles for individuals of age 20 to 100 in the case of unemployment risk (panels (a) and (b)) and unemployment
traps (panels (c) and (d)). The parameters governing the human capital erosion during short-term and long-term
unemployment spells are Ψ1 = 0 and Ψ2 = 0.6. Financial wealth is expressed in ten thousands of U.S. dollars.

No unemployment traps

(a) (b)

Unemployment traps

(c) (d)

33
Figure 5: Optimal and suboptimal life-cycle profiles
This figure contrasts the optimal (solid line) and suboptimal life cycle profiles (dotted line: “Age Rule”; dashed-
dotted line: “Target Date Fund rule”; dashed line: “unaware of traps”, i.e. optimization without taking into
account the existence of unemployment traps). Financial wealth and consumption are expressed in ten thousands
of U.S. dollars.

(a) Equity portfolio share

(b) Consumption

(c) Financial wealth

34
Figure 6: Income profiles conditional on welfare gains
This figure displays mean income profiles conditional on welfare gains from becoming aware of traps. The dotted
line represents the mean income profile for individuals with welfare gain below the 5-th percentile. The solid and
dash-dotted lines refer to individuals with welfare gains respectively at the average and above the 95th percentile.

Figure 7: Life-cycle profiles with unemployment traps: age-dependent long-term unemployment risk
This figure displays the average simulated stock investment and financial wealth accumulation life-cycle profiles
for individuals of age 20 to 100. The probability of entering long-term unemployment for an unemployed worker
is set to 0.15 in the baseline case, to 0.10 only for workers younger than 50 in Case 1, to 0.10 for all workers in
Case 2. Human capital erosion: Ψ1 = 0 and Ψ2 = 0.6. Financial wealth is expressed in ten thousands of U.S.
dollars.
(a) (b)

35
Figure 8: Life-cycle profiles with unemployment traps: positive correlation between labor income and
stock returns
This figure displays the average simulated stock investment and financial wealth accumulation life-cycle profiles
for individuals of age 20 to 100. Positive correlation between labor income shocks and innovation to stock
returns: ρsY = 0.2. Human capital erosion: Ψ1 = 0 and Ψ2 = 0.6. Financial wealth is expressed in ten
thousands of U.S. dollars.
(a) (b)

Figure 9: Life-cycle profiles with unemployment traps: recursive preferences

This figure displays the average simulated stock investment and financial wealth accumulation life-cycle profiles
for individuals of age 20 to 100. Preferences over consumption are recursive, represented by an Epstein Zin
utility function. Elasticity of intertemporal substitution varies from 0.1 to 0.5. Human capital erosion: Ψ1 = 0
and Ψ2 = 0.6. Financial wealth is expressed in ten thousands of U.S. dollars.

(a) (b)

36
Figure 10: Life-cycle profiles with unemployment traps: sensitivity to human capital erosion
This figure displays the average simulated stock investment and financial wealth accumulation life-cycle profiles
for individuals of age 20 to 100. Various cases are considered: no unemployment risk; unemployment traps
with alternative values of human capital erosion, i.e. with Ψ2 decreasing from 0.6 to 0.2 (in all cases Ψ1 = 0).
Financial wealth is expressed in ten thousands of U.S. dollars.

(a) (b)

Figure 11: Life-cycle profiles with unemployment traps: stochastic human capital erosion
The figure displays the average simulated stock investment and financial wealth accumulation life-cycle profiles
for individuals of age 20 to 100. Various cases are considered: no unemployment risk; unemployment traps with
deterministic human capital erosion (Ψ1 = 0 and Ψ2 = 0.6), unemployment traps with stochastic human capital
erosion. In the latter case, Ψ2 follows a beta distribution with shape parameters a and b. In particular, a=0.1
and b=0.4, 0.7 and 0.9, implying an expected value for Ψ2 equal to 0.20, 0.12 and 0.10, respectively. Financial
wealth is expressed in ten thousands of U.S. dollars.
(a) (b)

37