Benefit Provision in a Cyclic Economy
34 Pages Posted: 16 Mar 2012
Date Written: March 1, 2012
We discuss business cycle effects on the management of a trust fund set up to provide regular income on a continuing basis. Fund managers must find a balance between short-term and long-term variability of income. In our model the managers know that the expected return is mean-reverting, but they have limited capability of learning the true current state of the cycle. We consider policies that are optimal under constant relative risk aversion, and we contrast these with a parametric class of policies in which the asset mix is fixed and the estimated business cycle variable is only used in the consumption decision. In a calibration exercise, we find that optimal decisions are based on an exponentially weighted history of past asset returns with a half-time of about seven years. The tradeoff between short-term and long-term variability of income is illustrated by simulation results.
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