The Life Cycle Model with Recursive Utility: New insights on pension and life insurance contracts

For the conventional model with additive and separable expected utility, risk aversion and intertemporal elasticity of substitution in consumption sometimes play conflicting roles, in particular in life insurance and pensions. We propose to use recursive utility in the life cycle model, where we use the stochastic maximum principle to find the optimal solutions. This is a robust method which, among other things, do not require the Markov property. Optimal pension and life insurance contracts with these preferences involve consumption smoothing, not present in similar contracts using the conventional model. The model explains why aggregate consumption in society can be as smooth as implied by data, and at the same time be consistent with the relatively large, observed growth rate. Our analysis can also explain the prevalence of the two most common pension plans, defined benefit and defined contribution.