Stochastic lifestyling: optimal dynamic asset allocation for defined contribution pension plans

Andrew J. G. Cairns, David Blake and Kevin Dowd

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This 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.

Keywords: stoshastic control; optimal asset allocation; stochastic lifestyling; utility numeraire; habit formation; non-hedgeable salary risk; HJB equation (search for similar items in EconPapers)
JEL-codes: E21 G11 G23 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2004-09-13
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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http://eprints.lse.ac.uk/24831/ Open access version. (application/pdf)

Related works:
Journal Article: Stochastic lifestyling: Optimal dynamic asset allocation for defined contribution pension plans (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:24831

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