Sustainable
Asset Allocation in Retirement:
Stochastic
Optimization in a Downside Risk Framework
W. V. Harlow
Keith C. Brown
Abstract
Once
an individual has retired, asset allocation becomes a critical investment
decision. Unfortunately, there is no consensus on what the optimal allocation
should be for retirees of varying age, gender and risk tolerance. This study
analyzes the allocation question through a focus on the downside risks created
by uncertainty over investment returns and life expectancy. We find that the
range of appropriate equity asset allocations in retirement is strikingly low
compared to typical lifecycle and retirement funds now in the marketplace. In
fact, for retirement portfolios whose primary goal is to minimize the risk of
depletion and sustain withdrawals, optimal equity allocations range between 5
and 25 percent. This quite conservative level of
equity holdings changes little even when we significantly change our
assumptions on capital market returns. We even find that more aggressive equity
allocations, those that still retain some focus on depletion risk but also seek
to provide substantial bequests to heirs, are also relatively conservative in
their stock allocations. We conclude that the higher equity allocations
commonly used in retirement investment products significantly underestimate the
risks that these higher-volatility portfolios pose to the sustainability of
retirees’ savings and incomes.
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