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DISCUSSION PAPER PI-1005

LONGEVITY RISK, RETIREMENT SAVINGS AND FINANCIAL INNOVATION

João F. Cocco and Francisco J. Gomes

Over the last couple of decades there have been unprecedented, and to
some extent unexpected, increases in life expectancy which have raised
important questions for retirement savings. We study optimal consumption
and saving choices in a life-cycle model, in which we allow for changes in
the distribution of survival probabilities, according to the Lee-Carter (1992)
model. We allow individuals to hedge longevity risk through an endogenous
retirement decision and by investing in financial assets designed to hedge
this risk. We find that the welfare gains of investing in these assets are
substantial when longevity risk is calibrated to match the forwardlooking
projections of the US Social Security Administration and the UK Government
Actuaries Department. These gains are particularly large in a context of
declining benefits in defined benefit pension plans. Finally, we draw
implications for optimal security design.