Life-Cycle Asset Allocation Research Articles

Household Interest Rate Risk Management

I investigate household interest rate risk management by solving a life-cycle asset allocation model that includes mortgage and bond portfolio choice. I find that most investors prefer an adjustable-rate mortgage and thereby save on the bond risk premium that is contained in fixed-rate mortgage payments. Only older, risk-averse investors hold some fixed-rate mortgage debt. Together with a position in short-term bonds this enables them to hedge against changes in the real interest rate, while the inflation exposure of the debt and bond positions cancel out. Hedging house price changes with bonds only occurs at the end of the life cycle. Early in the life cycle short-sale constraints prevent an effective hedge.

Life Cycle Asset Allocation in the Presence of Housing and Tax-Deferred Investing

Life Cycle Asset Allocation in the Presence of Housing and Tax-Deferred Investing

Life-cycle asset allocation and consumption using stochastic linear programming

We consider optimal consumption and (strategic) asset allocation of an investor with uncertain lifetime. The problem is solved using a multi-stage stochastic linear programming (SLP) model to be able to generalize the closed-form solution obtained by Richard (1975). We account for aspects of the application of the SLP approach which arise in the context of life-cycle asset allocation, but are also relevant for other problems of similar structure. The objective is to maximize the expected utility of consumption over the lifetime and of bequest at the time of death of the investor. Since we maximize utility (rather than other objectives which can be implemented more easily) we provide a new approach to optimize the breakpoints required for the linearization of the utility function. The uncertainty of the problem is described by discrete scenario trees. The model solves for the rebalancing decisions in the first few years of the investor's lifetime, accounting for anticipated cash flows in the near future, and applies Richard's closed-form solution for the long, subsequent steady-state period. In our numerical examples we first show that available closed-form solutions can be accurately replicated with the SLP-based approach. Second, we add elements to the problem specification which are usually beyond the scope of closed-form solutions. We find that the SLP approach is well suited to account for these extensions of the classical Merton setting.

Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds?

Lifecycle funds offered by retirement plan providers allocate aggressively to risky asset classes when the employee participants are young, gradually switching to more conservative asset classes as they grow older and approach retirement. This approach focuses on maximizing growth of the accumulation fund in the initial years and preserving its value in the later years. The authors simulate terminal wealth outcomes based on conventional lifecycle asset allocation rules as well as on contrarian strategies that reverse the direction of asset switching. The evidence suggests that the growth in portfolio size over time significantly impacts the asset allocation decision. Due to the portfolio size effect that is observed by the authors, the terminal value of accumulation in retirement accounts is influenced more by the asset allocation strategy adopted in later years relative to that adopted in early years. By mechanistically switching to conservative assets in the later years of a plan, lifecycle strategies sacrifice significant growth opportunity and prove counterproductive to the participant9s wealth accumulation objective. The authors9 conclude that this sacrifice does not seem to be compensated adequately in terms of reducing the risk of potentially adverse outcomes. <b>TOPICS:</b>Retirement, fixed-income portfolio management, in wealth management

Using Value at Risk to Enhance Asset Allocation in Life-Cycle Investment Funds

This article presents a straightforward approach to incorporate a Value at Risk (VaR) constraint into the asset allocation mechanism of life-cycle investment funds. It makes use of tactical tilts in asset allocation which take into account current market conditions, risk tolerance, and time to retirement. The attractive feature of this strategy is that it is easy to implement and does not require assumptions about the distribution of returns or estimating investor’s utility function. It also has the potential to deliver significantly higher terminal wealth to fund participants than present life-cycle asset allocation strategies. <b>TOPICS:</b>VAR and use of alternative risk measures of trading risk, long-term/retirement investing, portfolio management/multi-asset allocation

Using hedge funds to enhance asset allocation in life cycle pension funds

Life cycle investment funds are one of the fastest growing segments in the defined contribution pension industry. Despite concerns over long-term investment performance, many life cycle products continue to remain focused on traditional core allocations to US stocks and US bonds, with very little exposure to alternative asset classes such as commodities or global real estate. This paper outlines a methodology for assessing the potential enhancement to long-term performance that may arise from the inclusion of hedge funds into life cycle investment products. The results indicate a potential role for hedge funds. It is argued that exposure can be most efficiently gained via investable hedge fund of fund indices or by using widely available technology to replicate hedge fund returns via common risk factors. Because the approach developed in this paper can be easily modified, it could prove useful to financial planners, investors, portfolio managers and policy makers in assessing the risk and return characteristics of various life cycle asset allocation strategies.

Household Interest Rate Risk Management

I investigate household interest rate risk management by solving a life-cycle asset allocation model that includes mortgage and bond portfolio choice. I find that most investors prefer an adjustable-rate mortgage, and thereby save on the bond risk premium that is contained in fixed-rate mortgage payments. Only older, risk-averse investors hold some fixed-rate mortgage debt. Together with a position in short-term bonds this enables them to hedge against changes in the real interest rate, while the inflation exposure of the debt and bond positions cancel out. Hedging house price changes with bonds only occurs at the end of the life cycle. Early in the life cycle short-sale constraints prevent an effective hedge.

Measuring the Performance of Life-Cycle Asset Allocation

Measuring the Performance of Life-Cycle Asset Allocation

Human Capital as an Asset Mix and Optimal Life-Cycle Portfolio: An Analytical Solution

This study examines life-cycle optimal consumption and asset allocation in the presence of human capital. Labor income seems like a money market mutual fund whose balance in one or two years is predictable but a wide dispersion results after many years, reflecting fluctuations in economic conditions. We use the martingale method to derive an analytical solution, finding that Merton's well-known constant-mix strategy is still true after incorporating human capital from the perspective of total wealth management. Moreover, the proportion in risky assets implicit in the agent's human capital is the main factor determining the optimal investment strategy. The numerical examples suggest that young investors should short stocks because their human capital has large market exposure. As they age, however, their human capital becomes bond-like, and thus they have to hold stocks to achieve optimal overall risk exposure.

Life-cycle asset allocation with annuity markets

This paper derives the optimal consumption and portfolio choice pattern over the life-cycle for households facing uninsurable labor income risk, ruin risk, stochastic capital markets, and uncertain lifetime. Our model posits a dynamic utility maximizer with CRRA and Epstein/Zin preferences who has access to liquid stocks, bonds, and illiquid life annuities. We show that a considerable fraction of wealth is gradually annuitized until retirement and beyond to skim the mortality credit. The remaining liquid wealth is mainly invested in stocks to compensate for riskless investment in life annuities. The model allows us to assess the economic importance of common explanations for the empirically low annuity demand by analyzing participations rates, annuitization fractions, and welfare effects.

Life-Cycle Asset Allocation and Optimal Consumption Using Stochastic Linear Programming

We consider optimal consumption and (strategic) asset allocation of an investor with uncertain lifetime. The problem is solved using a multi-stage stochastic linear programming (SLP) model to be able to generalize the closed-form solution obtained by Richard (1975). We account for aspects of the application of the SLP approach which arise in the context of life-cycle asset allocation, but are also relevant for other problems of similar structure. The objective is to maximize the expected utility of consumption over the lifetime and of bequest at the time of death of the investor. Since we maximize utility (rather than other objectives which can be implemented more easily) we provide a new approach to optimize the breakpoints required for the linearization of the utility function. The uncertainty of the problem is described by discrete scenario trees. The model solves for the rebalancing decisions in the first few years of the investor's lifetime, accounting for anticipated cash flows in the near future, and applies Richard's closed-form solution for the long, subsequent steady-state period. In our numerical examples we first show that available closed-form solutions can be accurately replicated with the SLP-based approach. Second, we add elements to the problem specification which are usually beyond the scope of closed-form solutions. We find that the SLP approach is well suited to account for these extensions of the classical Merton setting.

Life-Cycle Asset Allocation: A Model with Borrowing Constraints, Uninsurable Labor Income Risk and Stock-Market Participation Costs

We study life-cycle asset allocation in the presence of liquidity constraints and undiversifiable labor income risk. The model includes three different assets (cash, long-term government bonds and stocks) and it takes into account the life-cycle profile of housing expenditures. With a modest correlation between stock returns and earnings innovations, the mean share of wealth invested in stocks never exceeds 45% during working-life. Moreover, the combination of uninsurable human capital and borrowing constraints rationalizes the asset allocation puzzle of Canner, Mankiw and Weil (1997). Nevertheless we argue that asset allocation models must match another important feature of the data: a low stock market participation rate. Along this dimension the model provides a very modest improvement, still predicting a counterfactually high participation rate. We show that this arises from the link between risk aversion and prudence, implying that explanations for the participation puzzle based on the role of background risk are unlikely to succeed.