Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios

Abstract

Abstract Personal financial planning entails establishing retirement portfolio goals, which may be identified as specific portfolio target values. The problem of investing to build a retirement portfolio that achieves a specified value at retirement can be modeled as a dynamic multiperiod portfolio problem. Although theoretically robust, the dynamic programming approach to multiperiod portfolio analysis is computationally intractable. In contrast, this paper uses Monte Carlo simulation to analyze specific asset allocations in the context of multiperiod planning. We consider achieving a target portfolio value at a specific point in time. We conclude that 'life-cycle funds' that reduce equity allocations over time fail to increase the likelihood of reaching a targeted portfolio value compared with fixed asset allocation models (e.g., 80% equity/20% bond). © 2007 Academy of Financial Services. All rights reserved. JEL classifications: D14; G11 Keywords: Retirement planning; Portfolio risk 1. Introduction The majority of the vast literature on portfolio analysis considers the trade-off between risk and return in the context of a single period portfolio problem. Although variance and volatility are useful risk measures in the Capital Asset Pricing Model (CAPM), such measures of risk may have limited applicability for individual investors seeking to identify suitable asset allocations for multiperiod planning. Our models apply value at risk (VAR) methods for analyzing risk by examining probabilities of failing to achieve various target portfolio values. We contrast two different contribution strategies to illustrate the type of risks faced by the investor. First, we assume that investors specify a constant real dollar amount to be invested each year. The expected rates of return for a chosen asset allocation strategy are used to determine the expected value of the portfolio when the investor reaches a specific retirement age; for example, 30 years from time t. One of the risks with mis approach is that year-to-year uncertainty of actual portfolio returns may cause the portfolio to fall short of its target. Basing a contribution strategy on expected returns exposes any retirement portfolio to substantial risk of failing to reach targeted values. An investor may choose to increase the scale of annual contributions to reduce the probability of not reaching the targeted value, but extraordinarily high levels of contributions may be necessary to achieve desired risk reduction. Alternatively, an investor may adjust the contribution amounts so that targeted portfolio balances are achieved each year. This approach guarantees that the targeted portfolio value will be achieved at the time the investor retires. The risk inherent in this dynamic approach is that poor portfolio performance may require substantial increases in contribution amounts in some years to achieve year-to-year targeted portfolio amounts. The risks associated with the two contribution strategies contrasted above can be summarized as follows. Either an investor faces substantial variation of the value of the portfolio at retirement, or she faces substantial variation in the annual amounts saved and invested. In the former case, specified amounts are invested with no guarantee of reaching the investment target. In the latter case, the target is achieved but reaching the target may cost dearly in terms of annual contribution amounts. Regardless of contribution strategy, however, overall portfolio performance depends heavily upon asset allocation strategy. Recently financial institutions, especially mutual fund companies, have been promoting 'life-cycle' or 'target' mutual funds in which the asset allocation shifts as one approaches retirement age (e.g., Laise, 2006). Assets in life-cycle funds increased by 60% in 2005 to $70.1 billion (Ibid). Although specific asset allocations for each life-cycle fund differ, all of these allocation strategies advocate shifts away from equities in favor of bonds and cash as the investor approaches a retirement target date (e. …

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 30 citations exist upstream.