Money Illusion in Retirement Savings with a Minimum Guarantee

35 Pages Posted: 6 Dec 2023

See all articles by Catherine Donnelly

Catherine Donnelly

Heriot-Watt University

Gaurav Khemka

Australian National University (ANU)

William Lim

Australian National University (ANU)

Abstract

We investigate the impact of money illusion on the investment strategy and retirement outcomes of pre-retirees. Money illusion refers to the tendency of individuals to overlook the effects of inflation and focus on nominal rather than real terms. We solve and compare the optimal investment strategies for a pre-retiree who exhibits money illusion and aims to maximize the expected power utility of wealth at retirement, subject to a minimum guarantee constraint. While money illusion leads to welfare losses, implementing a minimum guarantee helps suppress these losses. However, guarantee constraints set under money illusion are ineffective in meeting inflation-adjusted constraints. Our findings emphasize the significant impact of money illusion on pre-retirees’ investment strategy and retirement outcomes in the form of utility loss and the risk of falling short of the minimum guarantee.

Keywords: Inflation, Asset allocation, Constrained optimization, Retirement outcomes, Money Illusion

Suggested Citation

Donnelly, Catherine and Khemka, Gaurav and Lim, William, Money Illusion in Retirement Savings with a Minimum Guarantee. Available at SSRN: https://ssrn.com/abstract=4638439 or http://dx.doi.org/10.2139/ssrn.4638439

Catherine Donnelly

Heriot-Watt University ( email )

Riccarton
Edinburgh EH14 4AS, Scotland EH14 1AS
United Kingdom

Gaurav Khemka (Contact Author)

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

William Lim

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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