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Lifetime Ruin Minimization: Should Retirees Hedge Inflation or Just Worry About it?

41 Pages Posted: 7 May 2011  

Huang Huaxiong

York University

Moshe A. Milevsky

York University - Schulich School of Business

Date Written: April 19, 2010

Abstract

Inflation for retirees is different from, and mostly higher than, the macroeconomic (average) inflation rate for the entire population. In the U.S. for example, the Consumer Price Index for the Urban population (CPI-U) calculated and reported by the Bureau of Labor Statistics (BLS) has a lesser known cousin called the CPI-E (for the elderly) in which the sub-component weights are based on the consumption patterns of Americans above the age of 62. This suggests that Inflation Linked Bond Funds (ILBFs) - whose individual component bond adjustments are based on broad population (CPI-U) inflation - might not be the best hedge for individual retirees’ cost of living. But then again, broad shocks to inflation are likely to impact both indices. So, motivated by the question, "Is it good enough?" The current paper uses lifetime ruin minimization (LRM) techniques to investigate the optimal allocation between an ILBF and a nominal investment fund for a retiree facing an exogenous liability. Our model trades-off the benefit of an imperfect hedge against the cost of lower investment growth. Alas, our numerical results suggest that although ILBFs can be a large part of the optimal retirement portfolio, it should treated as just another asset class in the broad optimization problem as opposed to a special or unique category.

Keywords: Personal Finance, Portfolio Choice, Investment Decisions, Optimization Techniques

JEL Classification: G11, D14, C61, G22, D91

Suggested Citation

Huaxiong, Huang and Milevsky, Moshe A., Lifetime Ruin Minimization: Should Retirees Hedge Inflation or Just Worry About it? (April 19, 2010). Available at SSRN: https://ssrn.com/abstract=1832615 or http://dx.doi.org/10.2139/ssrn.1832615

Huang Huaxiong

York University ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Moshe Arye Milevsky (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

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