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Optimal investment for defined-contribution pension plans under money illusion

Author

Listed:
  • Pengyu Wei

    (Nanyang Technological University)

  • Charles Yang

    (Florida Atlantic University)

Abstract

This paper examines the optimal asset allocation for defined-contribution pension plans in an inflationary economy under money illusion. The financial market consists of nominal bonds, inflation-linked bonds, and a stock index. The objective of the pension plan is to maximize the expected utility of a mixture of nominal and real wealth at retirement, as the plan member partially overlooks inflation and tends to think in terms of nominal rather than real monetary values. We obtain the optimal strategy and demonstrate the impacts of money illusion on asset allocation. In particular, money illusion significantly reduces investment in inflation-linked bonds. We also show that (even partially) overlooking inflation can lead to considerable welfare losses.

Suggested Citation

  • Pengyu Wei & Charles Yang, 2023. "Optimal investment for defined-contribution pension plans under money illusion," Review of Quantitative Finance and Accounting, Springer, vol. 61(2), pages 729-753, August.
    • Handle: RePEc:kap:rqfnac:v:61:y:2023:i:2:d:10.1007_s11156-023-01169-w
    DOI: 10.1007/s11156-023-01169-w
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    More about this item

    Keywords

    Defined-contribution pension plan; Money illusion; Inflation; Nominal bonds; Inflation-linked bonds;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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