Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion

Abstract

Retirees must draw down their accumulated assets in an orderly fashion so as not to exhaust their funds too soon. We derive the optimal retirement portfolio from a menu that includes payout annuities as well as an investment allocation and a withdrawal strategy, assuming risk aversion, stochastic capital markets, and uncertain lifetimes. The resulting portfolio allocation, when fixed as of retirement, is then compared to phased withdrawal strategies such a "self-annuitization" plan or the 401(k) "default" pattern encouraged under US tax law. Surprisingly, the fixed percentage approach proves appealing for retirees across a wide range of risk preferences, supporting financial planning advisors who often recommend this rule. We then permit the retiree to switch to an annuity later, which gives her the chance to invest in the capital market and "bet on death." As risk aversion rises, annuities first crowd out bonds in retiree portfolios; at higher risk aversion still, annuities replace equities in the portfolio. Making annuitization compulsory can also lead to substantial utility losses for less risk-averse investors.

One Possible Life Insurance Market Response to Ageing

“…The demand of various financial products varies as a function of the strength of the precautionary motive and the bequest motive. Because annuitants are reluctant to exchange a large lump sum for future promises to pay, some 23 Horneff et al (2006). 24 Sharpe et al (2007).…”

Determining Equivalent Charges on Flow and Balance in Individual Account Pension Systems

“…Stochastic lifestyling under terminal utility with habit formation is found and compared with other strategies in Cairns, Blake, and Dowd (2006). Finally, the reader interested in the analysis and optimal allocation during the decumulation phase can be referred, among others, to Blake et al (2001), Gerrard, Haberman, and Vigna (2004), Horneff, Maurer, Mitchell, and Dus (2006) and Gerrard, Haberman, and Vigna (2006).…”

Participant Perceptions and Decision-Making Concerning Retirement Benefits

“…For individuals who elect to receive a present value sum, there is an ongoing series of decisions concerning the investment and consumption of retirement assets. Factors suggested by the literature as possibly influencing the distribution decision include: other sources of retirement income (e.g., Social Security benefits and personal savings); competing desires for immediate consumption of retirement wealth and inter-generational wealth transfer; overestimates of future rates of investment return; underestimates of longevity, inflation, stock market volatility and health shock risks; and the undervaluing of annuities (Scott, Watson and Hu 2007;Hu and Scott 2007;Horneff et al 2006;Coile and Milligan 2006;Rohwedder and Van Soest 2006; Van Soest and Kapetyn 2006;Munnell and Sundén 2004;Dus, Maurer and Mitchell 2004).…”

“…Risk perceptions and motivations also play a potential role in understanding another retirement "puzzle" -why individuals undervalue annuities Horneff et al 2006). For most workers who participate in a defined contribution plan, the only distribution option is a present value sum.…”