Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans Under Loss Aversion

Pension Institute Discussion Paper No. PI-1112

45 Pages Posted: 1 Dec 2011

See all articles by David P. Blake

David P. Blake

City, University of London

Douglas Wright

City University London - The Business School

Yumeng Zhang

Solutions Group, Legal & General Investment Management

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Date Written: September 1, 2011

Abstract

Assuming loss aversion, stochastic investment and labor income processes, and a path-dependent target fund, we show that the optimal investment strategy for defined contribution pension plan members is a target-driven 'threshold' strategy. With this strategy, the equity allocation is increased if the accumulating fund is below target and decreased if it is above. However, if the fund is sufficiently above target, the optimal investment strategy switches discretely to 'portfolio insurance'. We show that under loss aversion, the risk of failing to attain the target replacement ratio is significantly reduced compared with target-driven strategies derived from maximizing expected utility.

Keywords: defined contribution pension plan, investment strategy, loss aversion, target replacement ratio, threshold strategy, portfolio insurance, dynamic programming

Suggested Citation

Blake, David P. and Wright, Douglas and Zhang, Yumeng, Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans Under Loss Aversion (September 1, 2011). Pension Institute Discussion Paper No. PI-1112, Available at SSRN: https://ssrn.com/abstract=1964686 or http://dx.doi.org/10.2139/ssrn.1964686

David P. Blake (Contact Author)

City, University of London ( email )

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HOME PAGE: http://www.pensions-institute.org/

Douglas Wright

City University London - The Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Yumeng Zhang

Solutions Group, Legal & General Investment Management ( email )

United Kingdom

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