Grasshoppers, Ants and Pre-Retirement Wealth: A Test of Permanent Income Consumers

Abstract

In this paper, it is shown that households who enter retirement with lower than ‘normal’ wealth do so because they had consistently followed near-sighted consumption rules during their working years. Using the Panel of Income Dynamics (PSID), household wealth in 1989 is predicted for a sample of 50-65 year old non-retired households using both current and past income, occupation, demographic and health characteristics. Using the residuals from this first stage regression, the sample of pre-retired households can be subsetted into households who save ‘lower’ than predicted and all other households. By construction, these households had similar opportunities to save; the average household in both these sub-samples is identical along all observable income and demographic characteristics. It is then shown that households in the low wealth residual sample had much larger declines in consumption upon retirement. It appears that retirement came as more of a surprise to these households. In the main part of the paper, I use the panel component of the PSID and analyze the consumption behavior of these households early in their lifecycle. It is shown that these low pre-retirement wealth households had consumption growth that responded to predictable changes in income during their early working years. No such behavior was found among the other pre-retired households. Moreover, the low residual households responded both to predictable income increases as well as predictable income declines, a result that is inconsistent with a liquidity constraints explanation. After ruling out other theories of consumption to explain these facts, it is concluded that households who entered retirement with lower than predicted wealth followed some near-sighted consumption rule of thumb early in their working lives.