Abstract
The United States’ aging population puts pressure on the pension system. Pension reforms consider putting more weight on individually managed retirement savings. Public policy and financial planners, being concerned with households making wise asset allocation decisions, need measures to evaluate individual investment performance. In this chapter, we illustrate two measures for the evaluation of asset allocation performance: a preference-free measure and a preference-based measure. We compare the suitability of both measures along several dimensions. The choice of the measure turns out to be important for the ranking of the performance of asset allocation decisions, and thus great care should be taken when deciding on public policy aimed at improving asset allocation behavior. Furthermore, we show that some classical rules of thumb used to mimic optimal life-cycle asset allocation strategies do not necessarily improve investment performance.
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Notes
- 1.
Further research on these and other important aspects regarding rationality of individual wealth accumulations (like choosing an optimal retirement age) is surveyed in Burtless (2010).
- 2.
All coefficients, except the dummy variables for Education (High) and Occupation (Retired) (both insignificant), are significant at the 1% level.
- 3.
We ran our analysis for savings ratios of 70 and 90%. The assumption on the savings ratio is Âcritical when calculating expected wealth values. For comparing different households’ performance, however, our results are robust to this assumption. That means the order of different households in their performance does not change.
- 4.
In particular, we use an inter-temporally-separable utility function and impose borrowing and short-selling constraints. We allow for a maximum age of the household of 100 years and account for uncertain lifetime. With again a starting age of 50 years, the utility function used is mathematically defined as: \( U(C)={\displaystyle \sum _{t=0}^{100-50}{\delta }^{t}{p}_{t+1}{U}_{t}\left({C}_{t}\right)}\), where C is consumption. The one-period utility function U t has constant relative risk aversion of 2, and δ, the subjective discount factor (the measure of the household’s time preference) is set to 0.97. The probability of a household to survive from period 0 at least another t years, p t , is calibrated according to the United States Life Tables 2003 (Arias, 2006). In case the household dies, utility is set to zero, which implies absence of bequest motives.
- 5.
Formally, one solves V *0 W 0,  L 0)  =  V 0 act W 0  +  ΔW 0,  L 0) for ΔW 0.
- 6.
For a further discussion of such approaches, see Kotlikoff (2008).
- 7.
Only under more rigorous assumptions, such models can be solved analytically (see, e.g., Lachance, 2010).
- 8.
This is demonstrated, for example, by the commercially available software ESPlanner (Kotlikoff, 2008).
- 9.
Preference-free evaluations of such funds are contained, for example, in Lewis (2008).
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Post, T., Schmit, J.T. (2011). Measuring the Performance of Life-Cycle Asset Allocation. In: Lamdin, D. (eds) Consumer Knowledge and Financial Decisions. International Series on Consumer Science. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-0475-0_18
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