A Life-Cycle Model with Unemployment Traps

This paper extends the life-cycle model allowing for a small risk of long-term unemployment with permanent effects on labour income. Such nonlinear income risk dampens both early consumption and early investment in equities. Their optimal portfolio share becomes flat in age due to the resolution of uncertainty, as the worker ages, concerning this personal disaster. Adopting such flatter investment profile, instead of an age rule, delivers mean welfare gains that are three times larger than in models with linear income shocks. The uninsured share of long-term unemployment risk therefore matters for the design of optimal portfolios during working years.