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
There are 2 versions of this paper
Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans Under Loss Aversion
Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans Under Loss Aversion
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
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