Target-Driven Investing: Optimal Investment Strategies in Defined Contribution Pension Plans under Loss Aversion

David Blake, Douglas Wright and Yumeng Zhang

Assuming the loss aversion framework of Tversky and Kahneman (1992), stochastic investment and labour income processes, and a path-dependent fund target, we show that the optimal investment strategy for defined contribution pension plan members is a target-driven ‘threshold’ strategy, whereby the equity allocation is increased if the accumulating fund is below target and is decreased if it is above. However, if the fund is sufficiently above target, the optimal investment strategy switches to ‘portfolio insurance’. We show that the risk of failing to attain the target replacement ratio is significantly lower with target-driven strategies than with those associated with the maximisation of expected utility.

Keywords: defined contribution pension plan, investment strategy, loss aversion, target replacement ratio,
threshold strategy, portfolio insurance, dynamic programming

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