Three aspects of investment decisions under terminal wealth constraints
Creators: name: Lim, William
Publisher: name: The Australian National University
Year: 2023

description: Pension investors in defined-contribution plans are responsible for making investment and withdrawal decisions regarding their pension savings. This thesis focuses on three aspects of investment decisions in the savings phase. First, we introduce a generalised option-based portfolio insurance strategy (GOPIS) which is an extension of the traditional option-based portfolio insurance (OBPI) and option-based performance participation proposed by Zagst et al. [J Bank Financ, 105 (2019), 44-61]. The investor can exogenously specify both the benchmark portfolio, to which the minimum guarantee is linked, and the venture portfolio, by which the investor participates in potential market gains. We extend the analysis of conditional stochastic dominance developed by Zagst et al. (2019) to enable the comparison of GOPISs with different venture and benchmark portfolios. We find that the venture portfolio, when determined endogenously to maximise the expected utility of an investor with a constant risk aversion utility function, is the Merton portfolio. We demonstrate that GOPIS can be configured to have a better prospect of delivering higher expected utility over traditional OBPIs. Second, we explore the impact of an investor's perception towards inflation risk on their investment strategy. Although pension investors are particularly exposed to the risk of inflation, few pre-retirement investment strategies incorporate explicit inflation-proofing. It is shown that ignoring inflation is costly in terms of a retiree's welfare, with reductions of up to 25% possible for the average retiree. More risk averse investors face even larger reductions. When wealth constraints (e.g. minimum guarantee) on the amount of pension savings at retirement are considered, we find that ignoring inflation by using nominal constraints gives a potential reduction in welfare of up to 36% for the average retiree. The results illustrate that nominal constraints are ineffective at reducing the risk of inflation. The conclusion is that investor ignore inflation at their peril. It must be included explicitly in retirement savings targets to improve retirement outcomes. Consequently, there should be greater investment in an index-linked bond or a similar asset. Finally, we investigate how well different investment strategies can give pension investors more certainty about their income in retirement, whilst allowing them to benefit from taking investment risks. Our model considers ongoing pension contributions to savings, prohibits short-selling and borrowings, and, when applicable, includes wealth constraints. We assume the investor may adopt a risk averse or a loss averse utility function, and income target for later evolves according to the stochastic labour income of the investor. Using a numerical dynamic programming approach under an expected utility maximising framework, we find that a loss aversion utility function gives a high degree of certainty about its desired wealth target and is robust to different market models. Imposing terminal wealth constraints does not improve the certainty of achieving the desired target enough to counter-balance the increased chance of obtaining a lower income. The power utility function is not robust to different market models and becomes too risk-averse with wealth constraints.