Optimal Portfolio Choice with Annuitization

We study the optimal consumption and portfolio choice problem over an individual's life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy.We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement.Subsequently, we determine how the investor optimally anticipates annuitization before retirement.We find that i) using information on term structure variables and risk premia significantly improves the optimal annuity choice, ii) restricting the annuity menu to nominal or inflation-linked annuities is costly for both conservative and more aggressive investors, and iii) adjustments in the optimal investment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are economically significant.This holds as well for sub-optimal annuity choices.The adjustment to hedge real interest rate risk is negligible.We estimate that the welfare costs of not taking these three factors into account at retirement are 9% for an individual with an average risk aversion ( = 5).Not hedging annuity risk before retirement causes an additional welfare costs between 1% and 13%, depending on the annuitization strategy implemented at retirement.optimal life-cycle portfolio choice;annuity risk

Labor Income and the Demand for Long-term Bonds

The riskless nature in real terms of inflation-linked bonds has led to the conclusion that inflation-linked bonds should constitute a substantial part of the optimal investment portfolio of long-term investors.This conclusion is reached in models where investors do not receive labor income during the investment period.Since such an income stream is often indexed with inflation, labor income in itself constitutes an implicit holding of real bonds.As such, the optimal investment in inflation-linked bonds is substantially reduced.By extending recently developed simulation-based techniques, we are able to determine the optimal portfolio choice among inflation-linked bonds, nominal bonds, and stocks for investors endowed with an indexed stream of income.We find that the fraction invested in inflation-linked bonds is much smaller than reported in the literature, the duration of the optimal nominal bond portfolio is lengthened, and the utility gains of having access to inflation-linked bonds are substantially reduced.We investigate as well the robustness of our results to time-variation in bond risk premia, the riskiness of labor income, and correlation between labor income risk and financial risks.We find that especially accounting for time-variation in bond risk premia and correlation between labor income risk and financial risks is important for both optimal portfolios and the utility gains of having access to inflation-linked bonds.inflation linked bonds;optimal lifetime investment;simulation-based portfolio choice

Essays on asset pricing

This dissertation contains six studies on asset pricing. It analyzes questions related to life-cycle portfolio choice in the presence of time-varying bond risk premia, annuity risk management, delegated and decentralized investment management, return predictability, and mortgage choice. The first three chapters examine normative portfolio and annuity choice problems. The common theme in the last three papers is to impose the restrictions following from economic theory in estimation. This enhances not only the efficiency of the estimates, but also deepens our understanding of the dynamics of asset prices and of the behavior of economic agents in financial markets.

Essays on Asset Pricing.

This dissertation contains six studies on asset pricing. It analyzes questions related to life-cycle portfolio choice in the presence of time-varying bond risk premia, annuity risk management, delegated and decentralized investment management, return predictability, and mortgage choice. The first three chapters examine normative portfolio and annuity choice problems. The common theme in the last three papers is to impose the restrictions following from economic theory in estimation. This enhances not only the efficiency of the estimates, but also deepens our understanding of the dynamics of asset prices and of the behavior of economic agents in financial markets.

Mortgage Timing

The fraction of newly-originated mortgages that are of the adjustable-rate (ARM) versus the fixed-rate (FRM) type exhibits a surprising amount of time variation. A simple utility framework of mortgage choice points to the bond risk premium as theoretical determinant: when the bond risk premium is high, FRM payments are high, making ARMs more attractive. We confirm empirically that the bulk of the time variation in household mortgage choice can be explained by time variation in the bond risk premium. This is true regardless of whether bond risk premia are measured using forecasters' data, a VAR term structure model, or a simple rule-of-thumb based on adaptive expectations. This simple rule-of-thumb moves in lock-step with mortgage choice, thereby lending further credibility to a theory of strategic mortgage timing by households.

Optimal Decentralized Investment Management

We study a decentralized investment problem in which a CIO employs multiple asset managers to implement and execute investment strategies in separate asset classes. The CIO allocates capital to the managers who, in turn, allocate these funds to the assets in their asset class. This two-step investment process causes several misalignments of objectives between the CIO and his managers and can lead to large utility costs on the part of the CIO. We focus on i) loss of diversification ii) different appetites for risk, iii) different investment horizons, and iv) the presence of liabilities. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. The optimal benchmark substantially mitigates the utility costs of decentralized investment management. These costs can be further reduced when the CIO can screen asset managers on the basis of their risk appetites. Each manager%u2019s optimal level of risk aversion depends on the asset class he manages and can differ substantially from the CIO%u2019s level of risk aversion.

Equity Yields

We study a new data set of prices of traded dividends with maturities up to 10 years across three world regions: the US, Europe, and Japan. We use these asset prices to construct equity yields, analogous to bond yields. We decompose these yields to obtain a term structure of expected dividend growth rates and a term structure of risk premia, which allows us to decompose the equity risk premium by maturity. We find that both expected dividend growth rates and risk premia exhibit substantial variation over time, particularly for short maturities. In addition to predicting dividend growth, equity yields help predict other measures of economic growth such as consumption growth. We relate the dynamics of growth expectations to recent events such as the financial crisis and the earthquake in Japan.

Optimal Portfolio Choice with Annuitization

We study the optimal consumption and portfolio choice problem over an individual's life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy.We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement.Subsequently, we determine how the investor optimally anticipates annuitization before retirement.We find that i) using information on term structure variables and risk premia significantly improves the optimal annuity choice, ii) restricting the annuity menu to nominal or inflation-linked annuities is costly for both conservative and more aggressive investors, and iii) adjustments in the optimal investment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are economically significant.This holds as well for sub-optimal annuity choices.The adjustment to hedge real interest rate risk is negligible.We estimate that the welfare costs of not taking these three factors into account at retirement are 9% for an individual with an average risk aversion ( = 5).Not hedging annuity risk before retirement causes an additional welfare costs between 1% and 13%, depending on the annuitization strategy implemented at retirement