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DISCUSSION PAPER PI-0808

Optimal Funding and Investment Strategies in Defined Contribution Pension Plans under Epstein-Zin Utility

David Blake, Douglas Wright and Yumeng Zhang

A defined contribution pension plan allows consumption to be redistributed from the plan
member’s working life to retirement in a manner that is consistent with the member’s personal
preferences. The plan’s optimal funding and investment strategies therefore depend on the
desired pattern of consumption over the lifetime of the member.
We investigate these strategies under the assumption that the member has an Epstein-Zin utility
function, which allows a separation between risk aversion and the elasticity of intertemporal
substitution, and we also take into account the member’s human capital.
We show that a stochastic lifestyling approach, with an initial high weight in equity-type
investments and a gradual switch into bond-type investments as the retirement date approaches
is an optimal investment strategy. In addition, the optimal contribution rate each year is not
constant over the life of the plan but reflects trade-offs between the desire for current
consumption, bequest and retirement savings motives at different stages in the life cycle,
changes in human capital over the life cycle, and attitude to risk.

Key words: defined contribution pension plan, funding strategy, investment strategy,
Epstein-Zin utility