Guarantees and habit formation in pension schemes. A critical analysis of the floor-leverage rule

The recent academic literature suggests that investors regard a large part of their previous consumption as necessary for subsistence, and derive utility only from the excess of consumption above the subsistence level; this is referred to as habit formation. The habit formation of pension participants might have a great impact on the pension design and investment strategy of pension funds. Any pension plan contains guarantees, and habit formation might explain at least part of the demand for such guarantees. In this paper Frank de Jong and Yang Zhou (both TiU) examine the impact of habit formation preferences on the optimal portfolio and consumption choice and explore the implications for pension funds. The authors compare a rule of thumb for ratchet consumption, the Floor-Leverage rule for retirement, with the classic model of Merton.