Motivation Should investors reduce their equity exposure as retirement approach? Bodie Merton Samuelson: –under “normal” circumstances, this is the optimal.

Slides:



Advertisements
Similar presentations
The dark side of wage indexed pensions Evert Carlsson & Kalle Erlandzon FUR 2006.
Advertisements

1 BFS Coursework Seminar Part Two: Measurements of Risk.
Intertemporal Approach to the Current Account Part 2.
Drake DRAKE UNIVERSITY UNIVERSITE D’AUVERGNE Investing for Retirement: A Downside Risk Approach Tom Root and Donald Lien.
The Behavior of Interest Rates
Dividend Policy and Retained Earnings (Chapter 18) Optimal Dividend Policy Conflicting Theories Other Dividend Policy Issues Residual Dividend Theory Stable.
P.V. VISWANATH FOR A FIRST COURSE IN INVESTMENTS.
Behavioral Finance and Asset Pricing What effect does psychological bias (irrationality) have on asset demands and asset prices?
Capital Allocation to Risky Assets
© The McGraw-Hill Companies, 2005 Advanced Macroeconomics Chapter 16 CONSUMPTION, INCOME AND WEALTH.
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter.
AN INTRODUCTION TO PORTFOLIO MANAGEMENT
Chapter 6 An Introduction to Portfolio Management.
Vicentiu Covrig 1 Portfolio management. Vicentiu Covrig 2 “ Never tell people how to do things. Tell them what to do and they will surprise you with their.
Dynamic portfolio and mortgage choice for homeowners 0 Otto van Hemert, Frank de Jong Joost Driessen January 23th, 2006.
Pension Funds Performance Evaluation: a Utility Based Approach Carolina Fugazza Fabio Bagliano Giovanna Nicodano CeRP-Collegio Carlo Alberto and University.
Capital Allocation Between The Risky And The Risk-Free Asset
AN INTRODUCTION TO PORTFOLIO MANAGEMENT
1 ASSET ALLOCATION. 2 With Riskless Asset 3 Mean Variance Relative to a Benchmark.
A Switch Criterion for Defined Contribution Pension Schemes Bas Arts and Elena Vigna.
Saving and investing over the life cycle and the role of collective pension funds Lans Bovenberg, Ralph Koijen, Theo Nijman and Coen Teulings June 2007.
Sandy Lai Hong Kong University 1 Asset Allocation and Monetary Policy: Evidence from the Eurozone Harald Hau University.
Wealth accumulation and portfolio choice with taxable and tax-deferred accounts 0 Francisco Gomes, Alexander Michaelides, Valery Polkovnichenko Discussion.
Portfolio Analyzer and Risk Stationarity Lecture 23 Read Chapters 13 and 14 Lecture 23 Portfolio Analyzer Example.xlsx Lecture 23 Portfolio Analyzer 2015.XLSX.
Portfolio Management Lecture: 26 Course Code: MBF702.
Extending Life Cycle Models of Optimal Portfolio Choice: Integrating Flexible Work, Endogenous Retirement, and Investment Decisions with Lifetime Payouts.
Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to:
Portfolio Management-Learning Objective
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 7.
Endogenous growth Sophia Kazinnik University of Houston Economics Department.
Some Background Assumptions Markowitz Portfolio Theory
Investment Analysis and Portfolio Management Chapter 7.
6 Analysis of Risk and Return ©2006 Thomson/South-Western.
Reducing Social Security PRA Risk at the Individual Level — Lifecycle Funds and No-Loss Strategies Pathways to a Secure Retirement Conference, August 2006,
1 Combined Accumulation- and Decumulation Plans with Risk- Controlled Capital Protection 13th International AFIR Colloquium Maastricht, September 17th.
Efficient portfolios when housing is a hedge against rent risk ► Housing is a big part of household portfolios ► What does this mean for optimal portfolio.
Estimating pension discount rates David McCarthy.
McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7 Capital Allocation Between The Risky And The Risk-Free.
Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two Categories of Assets in Wealth MoneyBonds 1.Thus:M s + B s =
Optimal Gradual Annuitization: Quantifying the Cost of Switching to Annuities Optimal Gradual Annuitization: Quantifying the Cost of Switching to Annuities.
Risk and Return Professor Thomas Chemmanur Risk Aversion ASSET – A: EXPECTED PAYOFF = 0.5(100) + 0.5(1) = $50.50 ASSET – B:PAYS $50.50 FOR SURE.
Life-Cycle Asset Allocation with Annuity Markets: Is Longevity Insurance a Good Deal? Life-Cycle Asset Allocation with Annuity Markets: Is Longevity Insurance.
INVESTMENTS | BODIE, KANE, MARCUS Chapter Seven Optimal Risky Portfolios Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or.
Pension Reforms and the Allocation of Retirement Saving Renata Bottazzi University of Bologna, IFS and CHILD Tullio Jappelli University of Naples “Federico.
Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 6.
Do Individual Accounts Postpone Retirement? Evidence from Chile Alejandra C. Edwards and Estelle James.
Reducing Social Security PRA Risk at the Individual Level — Lifecycle Funds & No-Loss Strategies October 2006 David Wise Harvard and NBER Steven Venti.
© 2008 Morningstar, Inc. All rights reserved. 3/1/2008 LCN Role of Immediate Annuities in Retirement.
Intensive Actuarial Training for Bulgaria January 2007 Lecture 16 – Portfolio Optimization and Risk Management By Michael Sze, PhD, FSA, CFA.
The Average Propensity to Consume Out of Full Wealth: Testing a New Measure.
Option Valuation.
JESMOND MIZZI. Building the right portfolio to meet your investment objectives.
Portfolio Monitoring and Rebalancing 03/04/09. Monitoring and Rebalancing Why do we need to monitor a portfolio? What should we monitor? What are the.
Chapter 7 An Introduction to Portfolio Management.
High and Low Savers? Circumstances and Preferences Laurie Pounder.
CHAPTER TWENTY-ONE Portfolio Management CHAPTER TWENTY-ONE Portfolio Management Cleary / Jones Investments: Analysis and Management.
Optimal life-cycle portfolios for heterogeneous workers Fabio Bagliano Giovanna Nicodano University of Turin & CeRP-Collegio Carlo Alberto Carolina Fugazza.
Investment Regulations and DC Pensions Pablo Antolin, Financial Affair Division, OECD Asset allocation in uncertain time – CAMR Cass Business School, London,
Risk Analysis “Risk” generally refers to outcomes that reduce return on an investment.
1 Who are the Value and Growth Investors? Sebastien Betermier, Laurent E. Calvet, and Paolo Sodini Discussion by Frank de Jong Tilburg University 9 th.
The Capital Asset Pricing Model
Capital Allocation to Risky Assets
Risk and Return.
The Future of Pension Plan Funding London School of Economics UBS Pensions Research Programme Paper: Optimal Portfolio Allocation for Pension Funds in.
Saif Ullah Lecture Presentation Software to accompany Investment Analysis and.
22 Investors and the Investment Process Bodie, Kane, and Marcus
Chapter 21 Jones, Investments: Analysis and Management
22 Investors and the Investment Process Bodie, Kane, and Marcus
Capital Allocation to Risky Assets
Presentation transcript:

Motivation Should investors reduce their equity exposure as retirement approach? Bodie Merton Samuelson: –under “normal” circumstances, this is the optimal portfolio rule in a standard life cycle model –human capital, which decreases as retirement nears, provides a hedge against adverse financial outcomes This inspires Target Date Retirement Funds & default investment rules in DC plans –Vanguard: retirement date 2045 and 2015 respectively have stock allocations of 90% and 57% –Swedish PP: 100% percent in equities until 55, then gradually into fixed income

This paper Inserts bonds, beside equity and cash, in standard life cycle model 1. optimal portfolio share in stocks increases, or is constant, in age for reasonable parameter combinations –correlation btw permanent labour income shocks and stock returns –risk aversion –variance of income shocks 2. non investment in stocks by the young obtains without participation cost 3. large heterogeneity in optimal portfolio shares due to different work histories, especially for younger investors with relatively low saving 4. Implication: Tailored portfolio allocations rather than one-size-fits-all If default is needed, then an equally weighted portfolio is preferable

Previous Literature Benzoni et al (2007): long-run cointegration between labour income and stock returns Cocco (2004): presence of housing wealth Munk and Sorensen (2010): sensitivity of the expected labor income growth to the real short-term interest rate

Standard life cycle model power utility of consumption during life, conditional probability of survival labour income has a deterministic part, a temporary shock and a permanent shock, that can be correlated with stock returns liquidity constraints prevent from insuring against idiosyncratic shocks first pillar grants exogenous replacement ratio after retirement i.i.d. returns on stocks and risky bonds – correlated with each other riskless asset

Calibration (Cocco et al., 2005) Base (black), variation (red) working life 20-65, max age 100, US Mortality Tables discount factor 0.96 relative risk aversion 5, 8 variance of permanent & transitory shock to labour income σ ε ² = and σ n ² = σ ε ² = and σ n ² = 0.30 riskless rate 0.02 expected stock and bond risk premia 0.04 and 0.02 standard deviations of asset returns σ s =0.157 and σ b = 0.08 Stock-bond return correlation ρ sb = 0.2 Stock-labour income correlation ρ sY = 0 or 0.2 –CCGM (2001) find higher values, ranging from 0.33 for households with no high-school education to 0.52 for college graduates

7 Median Investment Profiles Base case –Insertion of bonds does not alter the age profile for equities Similar to Bodie et al. (1992) and Cocco et al.(2005), but risky bonds substitute for riskless asset –Prior to retirement, investment in equities in decreasing in age The asset allocation of the young is tilted towards stocks In the two decades before retirement it gradually shifts to risky bonds –After retirement, equity share is increasing in age As pension wealth is riskless, the retirees invest in stocks the more so the more financial wealth is disinvested; Flatter schedule with bequest

Median Investment Profiles Higher variance As the variance of labour income shocks increases: no change in the shape of age profiles savings and financial wealth increase, lowering equity investments the optimal share in stocks at 40 drops to 40% and keeps relatively constant until 65

Median Investment Profiles 0.2 i ncome-stock return correlation As correlation of labour income shocks increases: younger workers (20-25) accumulate stocks more slowly, since labor income is closer to an implicit holding of stocks; in high variance case, both savings and financial wealth increase, lowering the optimal equity share and restoring the decreasing profile For middle-aged workers asset allocation obtained in base case holds At 65 non financial income becomes certain (and therefore uncorrelated with stock returns), and the investor sharply rebalances her portfolio towards stocks

INVERTED Median Investment Profiles RRA 8; 0.2 labor income –stock returns correlation Higher risk aversion with positive correlation: upward sloping age profile for equities! age rule for bonds! median equity share never exceeds 0.2 before retirement normal variance case: workers do not participate when higher variance: workers save more and accumulate larger financial wealth, which leads to cautious participation in the equity market

Implications and Evidence on Age Profile for Equities Model Implication –Interact risk aversion and correlation to obtain equity portfolio shares that decrease, increase or stay constant in age. Missing interaction may explain divergent results on empirical relationship: –Bodie and Crane (1997) downward sloping –Heaton and Lucas (2004) horizontal –Ameriks and Zeldes (2004) increasing or hump shaped

Implications and Evidence on Non-Participation Implication: positive correlation is essential Haliassos and Michaelides (2003): not plausible. –Without bonds, correlation needed to achieve non participation is 0.5 instead of 0.2 –Early estimates: higher correlation for more educated groups and entrepreneurs, that typically invest in stocks. –Angerer and Lam (2009): higher correlation for craftsman, operatives, managers and administrators, farm laborers, private household workers and armed forces; and education below college degree.

13 Heterogeneity in portfolio shares 5 th, 50 th, 95 th percentiles of the cross-sectional distributions of portfolio shares conditional on age decreasing heterogeneity, before retirement at all ages, when background risk increases because financial wealth grows heterogeneity driven by working histories (idiosyncratic labour income shocks) together with low financial wealth to hedge them more similar optimal investments by workers with high risk aversion, because of higher financial wealth and lower heterogeneity

Heterogeneity in portfolio profiles Base Case “normal” labor shock variance“high” labor shock variance

Heterogeneity Positive income-stock returns correlation “normal” labor shock variance “high” labor shock variance

Heterogeneity Portfolio shares: Risk aversion 8 positive labor income –stock returns correlation (0.2)

17 Welfare Costs of Suboptimal Asset Allocation magnitude of the mean welfare costs is in the range of bp in base case –higher risk aversion bp 1/3 has lower welfare costs than a modifed age rule (100-age)/2 Welfare costs is measured in certainty equivalent return –if management cost of optimal allocation exceeds 460bp, then 1/3 default investment option is better for all risk aversion and correlation

Welfare Costs of Suboptimal Asset Allocation (percentiles of financial wealth accumulated at 65) 18

19 Take-aways The optimal portfolio share invested in stock need not fall in age, even in normal circumstances Optimal default investment option ought to be tied to labour income risk characterics Equally weighted strategy better than age rule