Optimal Consumption and Portfolio Strategy for Retirees with Inflation

We develop a new dynamic model of optimal consumption and portfolio for retirees with inflation. We solve in closed-form the retiree’s value function using the dynamic programming approach. We therefore obtain the retiree’s optimal policies in closed-form. We find that both inflation expectations and inflation volatility affect the retiree’s optimal strategies especially via inflation-adjusted Sharpe ratio and subjective discount rate. Overall, inflation risk negatively affects the amount of optimal consumption because readiness for inflation requires a large amount of precautionary savings especially in the high inflation environment to finance high consumption costs. We find a reduction in the equity demand of retirees with inflation risk. Finally, neglecting inflation risk can be costly to retirees who aim to attain optimal choices towards the end of their human cycle, incurring substantial welfare costs.