Pension benefits, wealth accumulation, and capital market equilibrium: a life cycle hypothesis-based dynamic model

This paper examines the impacts of pension benefits on capital asset pricing in conjunction with wealth accumulation and retirement, and derives and tests a dynamic capital asset pricing model (CAPM) within the framework of a life cycle hypothesis-based dynamic model. The life cycle hypothesis-based dynamic model maximizes the expected utility of the individual's lifetime wealth in a continuous time process. An optimal solution of the individual's wealth path, incorporating the ages of retirement and death, is obtained and, based on the optimal wealth path, an analysis of comparative dynamics is pursued. The dynamic CAPM is then derived from the optimal wealth path; simulation and nonparametric tests are undertaken to evaluate the performance of the dynamic CAPM as compared to the traditional model which does not consider the impacts of pension benefits and the static model that incorporates the effects of pension benefits. The test results suggest that the proposed dynamic CAPM closely states the expected rate of return for a capital asset; that the new dynamic CAPM is preferable over the static model that is preferable over the traditional model; and that the three models considered are statistically distinguishable from one another.