Actuarial Seminar - Gaurav (Garry) Kemka (ANU)

Title: Optimal Investment under Terminal Wealth Constraints

This is joint work with William Lim (Australian National University)  & Catherine Donnelly (Heriot-Watt University)

Abstract : We study two aspects of making optimal investment decisions for retirement savers in the accumulation phase.  First, we explore the impact of an investor’s perception towards inflation risk on their investment strategy.  We find that mis-specifying inflation risk reduces the expected utility of the risk averse investors, and more risk averse investors face larger reductions.  For investors who adopt terminal wealth constraints (e.g. minimum guarantee), ignoring inflation results in real wealth not adhering to the real constraints.  The conclusion is that investors ignore inflation at their peril.

Secondly, we compare the retirement outcomes derived from the risk averse and loss averse utility functions.  We use a numerical dynamic programming approach and a model that includes ongoing pension contributions to savings, prohibits short-selling and borrowings, and, when applicable, includes wealth constraints. We find that the loss averse utility function, without wealth constraints, naturally results in a more favourable retirement income distribution that peaks at the investor's chosen income goal with some level of robustness.  We conclude that the investor can benefit from adopting a loss aversion-derived optimal investment strategy to target a sufficient level of income at retirement.