Stochastic lifestyling: optimal dynamic asset allocation for defined contribution pension plans
AbstractThis paper considers the asset-allocation strategies open to members of defined- contribution pension plans. We investigate a model that incorporates three sources of risk: asset risk and salary (or labour-income) risk in the accumulation phase; and interest-rate risk at the point of retirement. We propose a new form of terminal utility function, incorporating habit formation, that uses the plan member's final salary as a numeraire. The paper discusses various properties and characteristics of the optimal stochastic asset-allocation strategy (which we call stochastic lifestyling) both with and without the presence of non-hedgeable salary risk. We compare the performance of stochastic lifestlying with some popular strategies used by pension providers, including deterministic lifestyling (which involves a gradual switch from equities to bonds according to preset rules) and static strategies that invest in benchmark mixed funds. We find that the use of stochastic lifestyling significantly enhances the welfare of a wide range of potential plan members relative to these other strategies.
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Bibliographic InfoPaper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24831.
Length: 41 pages
Date of creation: 13 Sep 2004
Date of revision:
Stochastic control; Optimal asset allocation; Stochastic lifestyling; Utility numeraire; Habit formation; Non-hedgeable salary risk; HJB equation;
Other versions of this item:
- Cairns, Andrew J.G. & Blake, David & Dowd, Kevin, 2006. "Stochastic lifestyling: Optimal dynamic asset allocation for defined contribution pension plans," Journal of Economic Dynamics and Control, Elsevier, vol. 30(5), pages 843-877, May.
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
- E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
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