“The classic lifecycle strategy is far from optimal”

What is the focus of the paper?

In this paper, optimal lifecycle portfolio strategies have been derived for pension participants with different levels of risk aversion. To do this, the authors use scenarios published by DNB. In addition to equity risk these scenarios also take into account interest rate risk and inflation. The optimized strategies are restricted to be solely a function of age. They are compared to the classic Merton life cycle portfolios.

What are the main findings?

The study shows that for each risk profile, the optimal equity fraction in a portfolio is lower than classical theory predicts. The ‘Merton formula’ therefore underestimates the amount of equity risk.

The optimal interest rate exposure differs by life stage: at a younger age, interest rate risks have virtually no effect, and the optimal exposure is zero, while at an older age, after retirement, the investment in a nominal bond portfolio can rise to almost 100 percent.

The results show that the costs of suboptimal investment strategies can be substantial. A highly risk-averse pension participant will experience the optimal strategy for a participant with a high risk tolerance as extremely poor. For pension participants with a high risk tolerance who would have to follow the cautious path, the losses are smaller. A lifecycle portfolio optimized for the average participant limits the costs for all groups.

The (optimal) allocations are highly sensitive to the way in which the first pillar (AOW) is included in the calculations.

What are the implications?

  • The classic Merton formula does not generate an optimal life-cycle portfolio strategy. Attention must also be given to interest rate risks, changing market conditions and the higher probability of extreme events compared to the classic Merton environment.
  • Optimal strategies depend on more than just the level of relative risk aversion. It is equally important to take real income over the lifecycle into account.
  • With heterogeneous preferences among participants, there is added value in some differentiation in life cycle portfolio strategies.
  • It is important to include the first pillar benefits (AOW) in the calculations.