The relationship between the
optimal asset allocation and the functional form of power utility is
investigated for defined-contribution (DC) pension plans. The horizon dependence
of optimal pension portfolios is determined by the argument of the power
utility function. The optimal composition of pension portfolios is horizon
independent when terminal utility is a power function of wealth-to-wage ratio,
and deterministically horizon dependent when terminal utility is a function of
terminal wealth or replacement ratio (the pension-to-final wage ratio). The
optimal portfolios all contain a speculative component to satisfy the risk
appetite of DC plan members, which is dominated by bonds under usual market
assumptions. The optimal compositions of financial wealth on hand (the sum of
pension portfolio and the short-sold wage replicating portfolio) are stochas- tically
horizon dependent when wages are fully hedgeable and stochastic. The optimal
pension portfolios also have a preference free component to hedge wage risk,
when terminal utility is a function of wealth-to-wage ratio or replacement
ratio. A state variable dependent component in optimal pension portfolios
exists when terminal utility is a function of terminal wealth or replacement
ratio, but it disappears when terminal utility is a function of terminal
wealth-to-wage ratio and the risk premium is constant.
Cite this paper
Ma, Q. (2014). Optimal Asset Allocation Strategy for Defined-Contribution Pension Plans with Different Power Utility Functions. Open Access Library Journal, 1, e754. doi: http://dx.doi.org/10.4236/oalib.1100754.
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