Luis M. Viceira
Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)
May 22, 2007
This paper reviews recent advances in academic models of asset allocation for long-term investors, and explores their implications for the design of investment products that help investors save for retirement, particularly life-cycle funds and life-style (or balanced) funds. The paper argues that modern portfolio theory provides scientific foundation for the "risk-based" asset allocation strategies and the "age-based" asset allocation strategies that characterize life-style and life-cycle funds. Risk-based allocation strategies can be optimal in an environment where investors face real interest rate (or reinvestment risk), while human wealth considerations give rise to horizon effects in asset allocation. However, this theory also makes a number of suggestions about how life-style and life-cycle funds should be structured, and shows for which types of investors these funds are appropriate investment choices. Thus, modern portfolio theory provides only qualified support for these funds. Nevertheless, the paper argues that properly designed life-cycle funds are better default investment choices than money market funds in defined-contribution pension plans. The paper also argues for the creation of life-cycle funds that allow for heterogeneity in risk tolerance, and for the creation of life-cycle funds specific to defined-contribution plans that can better account for the correlation between human capital and stock returns. It also suggests that investors who expect to receive Social Security benefits and pension income after retirement should choose a target retirement date for their funds based on their life-expectancy, not their expected retirement date.
Number of Pages in PDF File: 37
Keywords: Mutual funds, lifecyce funds, lifestyle funds, risk-based investing, age-based investing, long-term asset allocation, asset allocation, portfolio choice,investing, human capital, pension funds, defined-contribution pension funds, retirement, Social Security, TIPS, inflation, mean-reversion, risk
JEL Classification: D91, G11, G20, G23, G28, J26
Date posted: May 25, 2007