Benefit provision in a cyclic economy

We discuss business cycle effects on the management of a trust fund set up to provide regular income on a continuing basis. Fund managers must find a balance between short-term and long-term variability of income. In our model the managers know that the expected return is mean-reverting, but they have limited capability of learning the true current state of the cycle. We consider policies that are optimal under constant relative risk aversion, and we contrast these with a parametric class of policies in which the asset mix is fixed and the estimated business cycle variable is only used in the consumptiondecision. In a calibration exercise, we ¯nd that optimal decisions are based on an exponentially weighted history of past asset returns with a half-time of about seven years. The tradeoff between short-term and long-term variability of income is illustrated by simulation results.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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