On the Asset Allocation of a Default Pension Fund

We characterize the optimal default fund in a defined contribution (DC) pension plan. Using detailed data on individuals' holdings inside and outside the pension system, we find substantial heterogeneity within and between passive and active investors in terms of labor income, financial wealth, and stock market participation. We build a life‐cycle consumption‐savings model, with a DC pension account and an opt‐out/default choice, that produces realistic investor heterogeneity. Relative to a common age‐based allocation, implementing the optimal default asset allocation implies a welfare gain of 1.5% during retirement. Much of the gain is attainable with a simple rule of thumb.     

Management of Portfolio Depletion Risk through Optimal Life Cycle Asset Allocation

Members of defined contribution (DC) pension plans must take on additional responsibilities for their investments, compared to participants in defined benefit (DB) pension plans. The transition from DB to DC plans means that more employees are faced with these responsibilities. We explore the extent to which DC plan members can follow financial strategies that have a high chance of resulting in a retirement scenario that is fairly close to that provided by DB plans. Retirees in DC plans typically must fund spending from accumulated savings. This leads to the risk of depleting these savings, that is, portfolio depletion risk. We analyze the management of this risk through life cycle optimal dynamic asset allocation, including the accumulation and decumulation phases. We pose the asset allocation strategy as an optimal stochastic control problem. Several objective functions are tested and compared. We focus on the risk of portfolio depletion at the terminal date, using such measures as conditional value at risk (CVAR) and probability of ruin. A secondary consideration is the median terminal portfolio value. The control problem is solved using a Hamilton-Jacobi-Bellman formulation, based on a parametric model of the financial market. Monte Carlo simulations that use the optimal controls are presented to evaluate the performance metrics. These simulations are based on both the parametric model and bootstrap resampling of 91 years of historical data. The resampling tests suggest that target-based approaches that seek to establish a safety margin of wealth at the end of the decumulation period appear to be superior to strategies that directly attempt to minimize risk measures such as the probability of portfolio depletion or CVAR. The target-based approaches result in a reasonably close approximation to the retirement spending available in a DB plan. There is a small risk of depleting the retiree’s funds, but there is also a good chance of accumulating a buffer that can be used to manage unplanned longevity risk or left as a bequest.     

Comparing Costs and Risks of Retirement Plans for Sponsors

This stochastic simulation analysis compares funding costs and volatilities for private sponsors of traditional defined benefit (DB), pension equity (PE), cash balance (CB), and defined contribution (DC) retirement plans. Plan provisions of equivalent benefit generosity in the different plan types are determined. The modeling includes current funding requirements and practices as well as a comprehensive set of uncertainties in asset and labor markets. The results show that costs and risks for sponsors vary significantly with plan types, investment and funding strategies, and participant demographics. The hybrid PE and CB plans exhibit characteristics of cost efficiency, as in the DB plan, and risk reduction, as in the DC plan, for plan sponsors under conventional investment strategies. These features are more saliently observed in the CB plan, but it is also more difficult to implement effective asset–liability management strategies for it.     

Defined Contribution Pension Plans: Sticky or Discerning Money?

Participants in defined contribution (DC) retirement plans rarely adjust their portfolio allocations, suggesting that their investment choices and consequent money flows are sticky and not discerning. However, participants’ inertia could be offset by DC plan sponsors, who adjust the plan's investment options. We examine these countervailing influences on flows into U.S. mutual funds. We find that flows into funds from DC assets are more volatile and exhibit more performance sensitivity than non‐DC flows, primarily due to adjustments to the investment options by the plan sponsors. Thus, DC retirement money is less sticky and more discerning than non‐DC money.     

Florida's Pension Election: From DB to DC and Back

During the year 2002, the State of Florida's 600,000 public employees were given the choice of converting their traditional defined benefit (DB) pension plan into an individual‐account defined contribution (DC) plan with full control over asset allocation and investment decisions. To mitigate some of the risk and uncertainty in the decision, the State granted each employee electing the DC plan an additional option to switch back (i.e., change their mind once) at any point prior to retirement. This option has been labeled the 2nd election by the State and the cost of reentry is fixed at the accumulated benefit obligation of their pension entitlement, which is the present value of the life annuity. Our article presents some original analytic insights relating to the optimal time and financial value of this unique 2nd election. Although our model is deterministic in nature, we believe that it provides a number of intuitive insights that are quite robust. Our results can be contrasted with Lachance, Mitchell, and Smetters (2003) . We estimate that the increase in retirement wealth that arises from having the 2nd election is equivalent to at most 30 percent in future value, and only when utilized optimally. Furthermore, for most State employees above the age of 45, the 2nd election has little economic value because the DB plan dominates the DC plan from day one. Of course, it remains to be seen what percent of Florida's 600,000 employees will elect to behave rationally with their newfound pension autonomy.     

Are target date funds the easy bake option?

Target date funds provide a simple, automated approach to retirement savings in defined contribution plans. The passing of the Pension Protection Act of 2006 has seen an increase in the popularity of these funds in the United States, becoming the default option for many plans. However, recent research findings have challenged the easy bake or ‘set-and-forget’ nature of target date funds. This study explores some of the critical design features of target date funds (which shifts an individual’s asset allocation from growth to defensive assets following a pre-set glidepath) against a simple balanced (or target risk) fund design. Using both time-weighted and dollar-weighted returns, our results suggest that there is more to achieving successful retirement outcomes than the investor simply selecting a proposed year of retirement. Our findings can perhaps be summarized by Einstein’s famous epithet, that in the murky world of retirement product design, everything should be made as simple as possible, but not simpler.     

Under the microscope: a closer look at the diversification and risk taking behavior of 401(k) participants and how plan sponsors can address key investing issues

This article reports the findings of research conducted on the asset allocation behavior of 250,000 401(k) plan participants. Included is discussion and analysis of what influences investment behavior and what employers can do to help their employees plan and invest more wisely for their own retirement.     

金融资产配置与违约风险:蓄水池效应,还是逐利效应？

本文以2007—2016年中国A股上市公司为研究对象,检验了企业金融资产配置对违约风险的影响。实证研究发现:金融资产持有量越多,企业的违约风险越低,金融资产配置的“蓄水池效应”显著;在货币政策宽松时期,金融资产配置导致的代理冲突显现,宽松的货币政策会抑制金融资产投资对违约风险的降低作用。政府规制也会有一定的公司治理作用,将产业政策纳入讨论发现:对于产业政策支持的行业来说,企业金融资产配置能够降低违约风险,但是宽松的货币政策会刺激管理层的短视投资行为,抑制政府规制的公司治理作用。进一步地,本文提出会计稳健性的提升是企业金融资产配置降低违约风险的重要路径。本文的研究结论丰富了企业金融资产配置动机和违约风险影响因素的讨论,能够为政府部门防范经济运行中的内在风险提供有益借鉴。     

The Impact of DC Pension Systems on Population Dynamics

Abstract

This study investigates the risk inherent in defined contribution (DC) pension plans on an individual and aggregate basis, based on U.S. data. Our aim is to gain insight into the consequences of a DC pension scheme becoming the predominant pillar of retirement income for an entire society. Using the stochastic simulated output of a DC flexible age-of-retirement model, we first determine the optimal investment strategies. We then examine the demographic retirement dynamics of an entire population of DC pension plan participants.

We observe that even for the most risk-averse plan members there is a high level of uncertainty in an individual’s age at retirement. At the aggregate population level, we find that this uncertainty does not get dampened to any great extent by a diversification effect. Instead, the central role played by the market in determining retirement dates results in significant variation in the dependency ratio (the ratio of retirees to workers) over time. In addition, an attempt to ameliorate the outcome by introducing additional realistic features in the DC population modeling did little to dampen this volatility, which suggests that countries dominated by DC schemes of this type may, over time, be exposed to significant risk in the size of its labor force.     

Saving and investing for early retirement: A theoretical analysis

We study optimal consumption and portfolio choice in a framework where investors adjust their labor supply through an irreversible choice of their retirement time. We show that investing for early retirement tends to increase savings and reduce an agent's effective relative risk aversion, thus increasing her stock market exposure. Contrary to common intuition, an investor might find it optimal to increase the proportion of financial wealth held in stocks as she ages and accumulates assets, even when her income and the investment opportunity set are constant. The model predicts a decrease in risk aversion following strong market gains like those observed in the nineties.     

401(k) Investment Decisions and Social Security Reform

Abstract

This paper uses the 1995 Survey of Consumer Finances to show that 401(k) participants with an underlying defined benefit plan are more likely to invest in equities than are participants whose 401(k) is their primary plan. This suggests that workers with a guaranteed source of retirement income are more likely to invest their other retirement assets more aggressively. Removing this guarantee might result in more conservative investment. Therefore, using current 401(k) asset allocation behavior to project income under a Social Security individual account system with reduced guaranteed benefits could overstate returns to these accounts, thus overstating their attractiveness relative to the current system.     

Equity risk versus retirement adequacy: asset allocation solutions for KiwiSaver

New Zealand's KiwiSaver superannuation system operates with a conservatively low asset allocation towards equity investments. Evidence suggests ‘conservative’ portfolios are riskier than portfolios holding more growth assets when considering shortfall risk. This study employs stochastic simulation to determine the optimal asset allocation to improve the balance of probabilities for retirement adequacy. The findings show that KiwiSaver default funds are excessively conservative, preventing investors from reaching their retirement goals. Increasing the asset allocation to equities across the range of available KiwiSaver funds is the only solution to significantly improve retirement adequacy in New Zealand given the low contribution rates observed.     

Worries and plans as individuals approach retirement

The primary objective of an employment-based retirement plan is to provide a secure and adequate income for workers throughout retirement. In the defined contribution (DC) framework, asset accumulation is a means to the end, but not the end. Drawing retirement income from savings and paying for health care expenses in retirement are the two issues that concern individuals the most as they approach retirement. This article examines the attitudes of near-retirees regarding these risks and their plans for managing them. The author discusses how DC plan design can have a major impact on how individuals convert their retirement savings to retirement income; differences in survey responses between those who have consulted a financial advisor or other financial professional and those who have not; and the role of trust in implementing advice.     

Wealth portfolios and elite professional athletes

Defined contribution pension plans typically rely on some type of lifecycle allocation investment strategy. This approach has recently been shown to be sub-optimal due to the portfolio size effect. The terminal wealth of individuals with steadily increasing earnings over time is significantly less when using a lifecycle strategy compared with a simple contrarian approach. The adverse effect of an inappropriate asset allocation strategy for investors with unorthodox earnings profiles, such as for professional athletes, can be greatly magnified. We demonstrate that strategies that exploit the portfolio size effect vastly dominates terminal wealth earned using lifecycle strategies for individuals who experience unorthodox earning profiles, particularly those generating high investable incomes early in life. While the lifecycle strategy contains some attractive features relating to risk aversion and diminishing utility from wealth, we demonstrate that for unorthodox earnings profiles the case for taking advantage of the portfolio size effect is particularly strong.     

Time to wealth goals in capital accumulation

This paper considers the problem of investment of capital in risky assets in a dynamic capital market in continuous time. The model controls risk, and in particular the risk associated with errors in the estimation of asset returns. The framework for investment risk is a geometric Brownian motion model for asset prices, with random rates of return. The information filtration process and the capital allocation decisions are considered separately. The filtration is based on a Bayesian model for asset prices, and an (empirical) Bayes estimator for current price dynamics is developed from the price history. Given the conditional price dynamics, investors allocate wealth to achieve their financial goals efficiently over time. The price updating and wealth reallocations occur when control limits on the wealth process are attained. A Bayesian fractional Kelly strategy is optimal at each rebalancing, assuming that the risky assets are jointly lognormal distributed. The strategy minimizes the expected time to the upper wealth limit while maintaining a high probability of reaching that goal before falling to a lower wealth limit. The fractional Kelly strategy is a blend of the log-optimal portfolio and cash and is equivalently represented by a negative power utility function, under the multivariate lognormal distribution assumption. By rebalancing when control limits are reached, the wealth goals approach provides greater control over downside risk and upside growth. The wealth goals approach with random rebalancing times is compared to the expected utility approach with fixed rebalancing times in an asset allocation problem involving stocks, bonds, and cash.     

Optimal holding period for assets that must be liquidated: A certainty equivalent wealth approach

Consumers often invest with a specific goal in mind and often know with some precision when the investment proceeds will be needed to achieve that goal. Because different investors have different attitudes toward risk and because different asset types exhibit different risk characteristics, there is often confusion as to the appropriate investment asset for a particular investor with a known investment horizon. It is also frequently, unclear as to whether investments should be switched to a less risky asset as time to liquidation becomes short. This paper addresses the issues of initial asset choice and the advisability of switching among assets when the investment goal date is known, employing the methodology of certainty equivalent wealth. In addition to suggesting optimal investment strategies for individuals based upon holding period and degree of risk aversion, it shows that switching investment assets produces suboptimal results.     

Risk Allocation in Retirement Plans: A Better Solution

The corporate world is reconsidering the cost‐effectiveness of defined benefit pension plans while contemplating a change to defined contribution plans. This article begins by examining the three primary risks faced by sponsors of most DB pension plans—investment risk, interest rate risk, and longevity risk—and shows how shifting these risks to employees through a DC plan would affect both the corporation and the individual. Although DC plans clearly help companies manage risks, they provide at best an incomplete solution for individual participants. This article describes an innovation in pension design—the Retirement Shares Plan (RSP)—that combines many of the best features of DB and DC plans. An RSP provides:

• ? predictable and stable cost to the plan sponsor, with little chance of unfunded liabilities;
• ? lifetime income, guaranteeing that retirees will never outlive their benefits;
• ? a benefit accrual pattern comparable to that of traditional pension plans that preserves value for older, long‐service employees; and
• ? potential inflation protection for retirees.

The RSP accomplishes this by allocating risk to sponsors and individuals differently than either a traditional DB plan or a DC plan. Unlike most DB plans, the RSP shifts investment and interest rate risks from plan sponsors to participants. Unlike DC plans, the RSP keeps longevity risk with the sponsor.     

Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income

This paper examines how risky labor income and retirement affect optimal portfolio choice. With idiosyncratic labor income risk, the optimal allocation to stocks is unambiguously larger for employed investors than for retired investors, consistent with the typical recommendations of investment advisors. Increasing idiosyncratic labor income risk raises investors' willingness to save and reduces their stock portfolio allocation towards the level of retired investors. Positive correlation between labor income and stock returns has a further negative effect and can actually reduce stockholdings below the level of retired investors.