The Impact of Longevity Risk on the Optimal Contribution Rate and Asset Allocation for Defined Contribution Pension Plans

Abstract

This research studies the interaction between longevity risk and asset allocation for a defined contribution pension plan. We investigate the investment strategy during the accumulation phase to deal with longevity risk during the decumulation phase. The longevity risk is demonstrated using the U.K. mortality experience for pensioners. We experiment with three patterns of mortality: base, projection and stochastic mortality rates. The optimal asset allocation and contribution rate are determined by minimizing the variance of the error between the value of pension fund and required pension fund plus the square of the expected value of the error. The required pension fund is decided by the pension fund target, measured using the income replacement ratio. We consider four assets in the asset allocation and observe four types of changes to the rebalancing investment strategies. The results show a life cycle investment strategy and indicate that longevity risk can be hedged by either raising the contribution rate or setting a more aggressive asset allocation.