Abstract
This paper investigates the optimal investment strategy for a defined contribution (DC) pension plan during the decumulation phase which is risk-averse and pays close attention to inflation risk. The plan aims to maximize the expected constant relative risk aversion (CRRA) utility from the terminal real wealth by investing the fund in a financial market consisting of an inflation-indexed bond, an ordinary zero coupon bond and a risk-free asset. We derive the optimal investment strategy in closed-form using the dynamic programming approach by solving the related Hamilton-Jacobi-Bellman (HJB) equation. The results reveal that, with any level of the parameters, an inflation-indexed bond has significant advantage to hedge inflation risk.
Highlights
Introduction and MotivationAn asset allocation problem incorporating inflation risk for individual investors has been studied by many researchers
Inflation-indexed bond is defined as an financial instrument that delivers a defined payoff indexed by inflation at maturity time, which can be utilized to hedge against inflation risk
As the decumulation phase of a defined contribution (DC) pension scheme is confronted with inflation risk, this paper applies the inflation bond in this period and considers an optimal control problem, which continuously decides weights of investment in different assets, including a zero coupon bond, an inflation-indexed bond and a riskless asset, in order to maximize the terminal wealth with the consideration of the influence of inflation
Summary
An asset allocation problem incorporating inflation risk for individual investors has been studied by many researchers. As the decumulation phase of a DC pension scheme is confronted with inflation risk, this paper applies the inflation bond in this period and considers an optimal control problem, which continuously decides weights of investment in different assets, including a zero coupon bond, an inflation-indexed bond and a riskless asset, in order to maximize the terminal wealth with the consideration of the influence of inflation. Another motivation of our work is to investigate whether the investment efficiency is improved by the inflation-index bond. The comparative study shows that investment in the indexed bond has significant advantage to hedge inflation risk
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