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Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion

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Author Info
Wolfram Horneff (Johann Wolfgang Goethe-University of Frankfort)
Raimond Maurer (Johann Wolfgang Goethe-University of Frankfort)
Olivia Mitchell (Wharton School, University of Pennsylvania)
Ivica Dus (Johann Wolfgang Goethe-University of Frankfort)

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Abstract

Retirees must draw down their accumulated assets in an orderly fashion so as not to exhaust their funds too soon. We derive the optimal retirement portfolio from a menu that includes payout annuities as well as an investment allocation and a withdrawal strategy, assuming risk aversion, stochastic capital markets, and uncertain lifetimes. The resulting portfolio allocation, when fixed as of retirement, is then compared to phased withdrawal strategies such a "self-annuitization" plan or the 401(k) "default" pattern encouraged under US tax law. Surprisingly, the fixed percentage approach proves appealing for retirees across a wide range of risk preferences, supporting financial planning advisors who often recommend this rule. We then permit the retiree to switch to an annuity later, which gives her the chance to invest in the capital market and "bet on death." As risk aversion rises, annuities first crowd out bonds in retiree portfolios; at higher risk aversion still, annuities replace equities in the portfolio. Making annuitization compulsory can also lead to substantial utility losses for less risk-averse investors.

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Paper provided by University of Michigan, Michigan Retirement Research Center in its series Working Papers with number wp124.

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Length: 30 pages
Date of creation: Jul 2006
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Handle: RePEc:mrr:papers:wp124

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Michael D. Hurd & James P. Smith, 1999. "Anticipated and Actual Bequests," NBER Working Papers 7380, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Olivia S. Mitchell et al., 1999. "New Evidence on the Money's Worth of Individual Annuities," American Economic Review, American Economic Association, vol. 89(5), pages 1299-1318, December. [Downloadable!] (restricted)
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  3. Jeffrey R. Brown & James M. Poterba, 1999. "Joint Life Annuities and Annuity Demand by Married Couples," NBER Working Papers 7199, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. Blake, David & Cairns, Andrew J. G. & Dowd, Kevin, 2003. "Pensionmetrics 2: stochastic pension plan design during the distribution phase," Insurance: Mathematics and Economics, Elsevier, vol. 33(1), pages 29-47, August. [Downloadable!] (restricted)
  5. Joao F. Cocco, 2005. "Consumption and Portfolio Choice over the Life Cycle," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 18(2), pages 491-533. [Downloadable!] (restricted)
  6. Milevsky, Moshe Arye & Ho, Kwok & Robinson, Chris, 1997. " Asset Allocation via the Conditional First Exit Time or How to Avoid Outliving Your Money," Review of Quantitative Finance and Accounting, Springer, vol. 9(1), pages 53-70, July. [Downloadable!] (restricted)
  7. Ivica Dus & Raimond Maurer & Olivia S. Mitchell, 2003. "Betting on Death and Capital Markets in Retirement: A Shortfall Risk Analysis of Life Annuities versus Phased Withdrawal Plans," Working Papers wp063, University of Michigan, Michigan Retirement Research Center. [Downloadable!]
  8. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
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  9. Jeffrey R. Brown & Olivia S. Mitchell & James M. Poterba, 1999. "The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program," Center for Financial Institutions Working Papers 99-18, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
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  10. B. Douglas Bernheim, 1992. "How Strong are Bequest Motives? Evidence Based on Estimates of the Demand for Life Insurance and Annuities," NBER Working Papers 2942, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Robert C. Merton, 1982. "On Consumption-Indexed Public Pension Plans," NBER Working Papers 0910, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Martin Feldstein & Elena Ranguelova & Andrew Samwick, 1999. "The Transition to Investment-Based Social Security when Portfolio Returns and Capital Profitability are Uncertain," NBER Working Papers 7016, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. John F. Cogan & Olivia S. Mitchell, 2003. "Perspectives from the President's Commission on Social Security Reform," Journal of Economic Perspectives, American Economic Association, vol. 17(2), pages 149-172, Spring. [Downloadable!] (restricted)
  14. Brugiavini, Agar, 1993. "Uncertainty resolution and the timing of annuity purchases," Journal of Public Economics, Elsevier, vol. 50(1), pages 31-62, January. [Downloadable!] (restricted)
  15. Kingston, Geoffrey & Thorp, Susan, 2005. "Annuitization and asset allocation with HARA utility," Journal of Pension Economics and Finance, Cambridge University Press, vol. 4(03), pages 225-248, October. [Downloadable!]
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  16. Thomas Davidoff & Jeffrey R. Brown & Peter A. Diamond, 2005. "Annuities and Individual Welfare," American Economic Review, American Economic Association, vol. 95(5), pages 1573-1590, December. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Wolfram J. Horneff & Raimond H. Maurer & Olivia S. Mitchell & Michael Z. Stamos, 2007. "Money in Motion: Dynamic Portfolio Choice in Retirement," NBER Working Papers 12942, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Wei Sun & Robert Triest & Anthony Webb, 2006. "Optimal Retirement Asset Decumulation Strategies: The Impact of Housing Wealth," Working Papers, Center for Retirement Research at Boston College wp2006-22, Center for Retirement Research, revised Nov 2006. [Downloadable!]
    Other versions:
  3. Olivia S. Mitchell & John Piggott & Michael Sherris & Shaun Yow, 2006. "Financial Innovation for an Aging World," NBER Working Papers 12444, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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