Optimal Consumption and Retirement Time under Shortfall Risk Measure

Lijun Bo, Yijie Huang and Tingting Zhang

Papers from arXiv.org

Abstract: This paper studies the optimal portfolio, consumption, and endogenous early retirement problem within a benchmark tracking framework by incorporating a new relative performance evaluation. In this framework, the investor maximizes expected lifetime consumption utility while managing the maximum wealth shortfall relative to a benchmark, with shortfall-management costs that may differ before and after retirement. Mathematically, the problem is a hybrid stochastic control problem involving both regular controls and an optimal stopping time, in which the running maximum process records the investor's largest benchmark shortfall. We introduce an auxiliary reflected state process and establish an equivalent hybrid stochastic control problem. By proving the convex duality theorem, we technically transform the original problem into a two-dimensional pure optimal stopping problem with state reflection. This enables us to characterize the geometric structure of the stopping set and derive the feedback-form optimal retirement boundary, as well as optimal portfolio and consumption policies. Analytical examples and numerical simulations reveal a two-stage structure with more conservative investment and more aggressive consumption after retirement. Driven by the retirement option, the expected largest shortfall risk follows a pronounced U-shaped pattern with respect to wealth. Shortfall management costs, labor income, and leisure preference significantly influence retirement timing, investment, and consumption.

Date: 2026-06
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