Habit formation: Implications for pension plans

This paper discusses the implications of habit formation for pension plans. Habit formation utility preferences differ from the traditional ones in that they relax the assumption of time-separability. This realistic feature has substantial impact on the optimal portfolio and consumption strategy of pension investors. If pension plan members have preferences with habit formation, some forms of guarantees in the pension benefits are desirable. There are also several implications of habit formation for the investment policy. Habit formation induces a subsistence portfolio that ensures future habit consumption. In this subsistence portfolio, investors should invest in bonds to ensure the habit consumption. In contrast, they should invest more aggressively in the speculative portfolio to increase consumption rates. The habit persistence constrains investors’ risk taking behavior; this effect is more pronounced for young investors with low wealth.