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OPINION

The retirement decision

The retirement decision
December 31, 2014
The retirement decision

One of these reasons is that I don't know how much money I'll want after I retire. This isn't simply because I might need to go into a care home. It's because my tastes might change. Yes, I could get by quite nicely if my future spending resembles that of the past two years. But will it? When I do retire, I'd like to take a holiday abroad (for the first time since 1993). What if I get a taste for such ventures? Or what if I find that I spend more day to day when I'm not chained to a desk? Or what if, being able to get out more, I meet someone and want to spend money on her?

One finding in behavioural economics is that people are prone to what Matthew Rabin at the University of California at Berkeley calls projection bias: we project our current tastes into the future and so under-estimate the extent to which our preferences will change. This is why convertible cars sell better in summer than in winter, and why houses with swimming pools fetch a higher price in good weather - it's because we assume that our summer preferences will persist.

If I were to retire on the assumption that my future spending will be the same as my recent spending, I'd be taking the risk that my future tastes will change in the direction of more spending. That would be dangerous.

A second reason for not retiring is that my job isn't only a source of income. It's also a form of insurance. My salary protects me from stock market losses, because if or when the market falls, I can top up my wealth from additional savings.

Human capital is a way of diversifying equity risk. If I retire, I lose this insurance. Financial wealth isn't our only asset. So too is our human wealth, our ability to earn a living. We can generate a return on our time and patience, as well as on our money.

For me, human capital is like a (short-dated!) bond; it offers a stableish income. For those in riskier jobs, it is more like an equity, being a play upon economic conditions. For younger people, it is like a call option, offering a (small) chance of huge upside gains. (In fact, I suspect the concept of human capital makes more sense in terms of financial planning than it does in its original sense of explaining the returns to education - but that's another can of worms.)

Whatever it is, human capital is an asset which is not to be discarded lightly.

Which brings me to a third reason for not retiring. The retirement decision is asymmetric. If I decide to carry on working, I can change my mind and retire any time. But if I retire it won't be so easy to return to work; given my atrocious salesmanship and soft skills, I'll not be able to find so good a job. In this sense, retiring is a little like an irreversible investment.

And there's something economists know about irreversible investments. The choice of whether to undertake them or not is like the choice of whether to exercise a call option. Once the option is exercised it cannot be unexercised. And just because it is profitable to exercise an option it does not follow that we should immediately do so, because it might be even more profitable to do so later.

In this sense, I'm holding a call option on retiring. And the thing about options is that they are more valuable, the greater is uncertainty. (This is why uncertainty can reduce capital spending - it's because it causes firms to hold onto their investment options rather than exercise them.) And because there is uncertainty about both my spending needs and investment returns, I'd rather hold the call option on retiring than exercise it. This too argues for me to continue to work.

All this said, the decision here is a balanced one. On the one hand, if I retire I run the risk of outliving my wealth. But on the other, if I don't retire there's the risk that, in my old age, I will regret the life I missed because I was working.

Now, I appreciate that talking about oneself appears narcissistic. But I hope there's a point to all this. It's that an economist's way of thinking about retirement encompasses more than conventional financial advice. It entails thinking about how our liabilities might change because our preferences can change. It means thinking about our whole portfolio which includes labour income; the fact that this is impossible to value accurately does not mean it is unimportant. And it means thinking about the value of options.

What's more, whether I retire or not I am taking some sort of risk: either the risk that I'll outlive my wealth or the risk that my wealth will outlive me. Sometimes, there is no safe option and we must merely choose between different types of risk.