Age dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners
AbstractA defined contribution pension plan allows consumption to be redistributed from the plan member’s working life to retirement in a manner that is consistent with the member’s personal preferences. The plan’s optimal funding and investment strategies therefore depend on the desired profile of consumption over the lifetime of the member. We investigate these strategies under the assumption that the member is a rational life cycle financial planner and has an Epstein-Zin utility function, which allows a separation between risk aversion and the elasticity of intertemporal substitution. We also take into account the member’s human capital during the accumulation phase of the plan and we allow the annuitisation decision to be endogenously determined during the decumulation phase. We show that the optimal funding strategy involves a contribution rate that is not constant over the life of the plan but is age-dependent and reflects the trade-off between the desire for current versus future consumption, the desire for stable consumption over time, the member’s attitude to risk, and changes in the level of human capital over the life cycle. We also show that the optimal investment strategy during the accumulation phase of the plan is ‘stochastic lifestyling’, with an initial high weight in equity-type investments and a gradual switch into bond-type investments as the retirement date approaches in a way that depends on the realised outcomes for the stochastic processes driving the state variables. The optimal investment strategy during the decumulation phase of the plan is to exchange the bonds held at retirement for life annuities and then to gradually sell the remaining equities and buy more annuities, i.e., a strategy known as ‘phased annuitisation’.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 34277.
Date of creation: Sep 2011
Date of revision:
Defined Contribution Pension Plan; Funding Strategy; Investment Strategy; Epstein-Zin Utility; Stochastic Lifestyling; Phased Annuitisation; Dynamic Programming;
Other versions of this item:
- Blake, David & Wright, Douglas & Zhang, Yumeng, 2014. "Age-dependent investing: Optimal funding and investment strategies in defined contribution pension plans when members are rational life cycle financial planners," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 105-124.
- 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
This paper has been announced in the following NEP Reports:
- NEP-AGE-2011-11-14 (Economics of Ageing)
- NEP-ALL-2011-11-14 (All new papers)
- NEP-DGE-2011-11-14 (Dynamic General Equilibrium)
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.:
- Pierre-Olivier Gourinchas & Jonathan A. Parker, 1999.
"Consumption Over the Life Cycle,"
NBER Working Papers
7271, National Bureau of Economic Research, Inc.
- Gomes, Francisco J & Michaelides, Alexander, 2005.
"Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence,"
CEPR Discussion Papers
4853, C.E.P.R. Discussion Papers.
- Francisco Gomes & Alexander Michaelides, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," Journal of Finance, American Finance Association, vol. 60(2), pages 869-904, 04.
- 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.
- Inkmann, Joachim & Lopes, Paula & Michaelides, Alexander, 2010.
"How Deep is the Annuity Market Participation Puzzle?,"
CEPR Discussion Papers
7940, C.E.P.R. Discussion Papers.
- Joachim Inkmann & Paula Lopes & Alexander Michaelides, 2011. "How Deep Is the Annuity Market Participation Puzzle?," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 279-319.
- Joachim Inkmann & Paula Lopes & Alexander Michaelides, 2009. "How Deep is the Annuity Market Participation Puzzle?," Working Papers 2009-5, Central Bank of Cyprus.
- Paula Lopes & Alex Michaelides & Joachim Inkmann, 2009. "How deep is the annuity market participation puzzle?," 2009 Meeting Papers 239, Society for Economic Dynamics.
- Blake, David, 1996. "Efficiency, Risk Aversion and Portfolio Insurance: An Analysis of Financial Asset Portfolios Held by Investors in the United Kingdom," Economic Journal, Royal Economic Society, vol. 106(438), pages 1175-92, September.
- James M. Poterba & Lawrence H. Summers, 1989.
"Mean Reversion in Stock Prices: Evidence and Implications,"
NBER Working Papers
2343, National Bureau of Economic Research, Inc.
- Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
- Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
- Steffen Andersen & Glenn W. Harrison & Morten I. Lau & E. Elisabet Rutström, 2008. "Eliciting Risk and Time Preferences," Econometrica, Econometric Society, vol. 76(3), pages 583-618, 05.
- Susan Laury & Melayne McInnes & J. Todd Swarthout, 2012.
"Avoiding the curves: Direct elicitation of time preferences,"
Journal of Risk and Uncertainty,
Springer, vol. 44(3), pages 181-217, June.
- Susan K. Laury & Melayne Morgan McInnes & J. Todd Swarthout & Erica Von Nessen, 2011. "Avoiding the Curves: Direct Elicitation of Time Preferences," Experimental Economics Center Working Paper Series 2011-01, Experimental Economics Center, Andrew Young School of Policy Studies, Georgia State University, revised Mar 2012.
- Kim, Myung Jig & Nelson, Charles R & Startz, Richard, 1991.
"Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence,"
Review of Economic Studies,
Wiley Blackwell, vol. 58(3), pages 515-28, May.
- Myung Jig Kim & Charles R. Nelson & Richard Startz, 1991. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," NBER Working Papers 2795, National Bureau of Economic Research, Inc.
- Constantijn W.A. Panis, 2003. "Annuities and Retirement Satisfaction," Working Papers 03-17, RAND Corporation Publications Department.
- Thomas Leonard, 2008. "Richard H. Thaler, Cass R. Sunstein, Nudge: Improving decisions about health, wealth, and happiness," Constitutional Political Economy, Springer, vol. 19(4), pages 356-360, December.
- Francisco J. Gomes & Laurence J. Kotlikoff & Luis M. Viceira, 2008.
"Optimal Life-Cycle Investing with Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds,"
American Economic Review,
American Economic Association, vol. 98(2), pages 297-303, May.
- Francisco J. Gomes & Laurence J. Kotlikoff & Luis M. Viceira, 2008. "Optimal Life-Cycle Investing with Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds," NBER Working Papers 13966, National Bureau of Economic Research, Inc.
- David Blake & Andrew Cairns & Kevin Dowd, 2007. "The Impact of Occupation and Gender on Pensions from Defined Contribution Plans," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 32(4), pages 458-482, October.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Ekkehart Schlicht).
If references are entirely missing, you can add them using this form.