Speaker(s): Catherine Donnelly (Heriot-Watt University)
In the UK, more and more people are asked, how do they want to invest for retirement. They are given 'attitude to risk' questionnaires to elicit their attitude to investment risk. Given a choice between investing their contributions in the confusing financial world of equities, bonds and other assets, and choosing the 'default option', most go for the default option. Typically, this is a lifestyle strategy which has the merit of being easy to explain. Yet the fundamental question of how they want to invest their pension contributions is the wrong question to ask of most people. It is too difficult and technical a question to answer for most people. They lack the financial knowledge to understand the choices available to them and the implications of their chosen investment strategy.
Instead, the question should ask them, how much income do they want in retirement. Specifically, how much inflation-proofed income. This point is highlighted by Merton (2014), who emphasizes that risk should be measured as failure to reach a certain retirement income.
Applying the setup of Merton (2014), we consider a retirement investor who fixes a target level of retirement income. This is the maximum income that the investor will receive in retirement. The investor is told the probability of achieving the maximum income, given their current situation. A minimum income is also fixed, which is a lower value than the target. The investor's retirement income will never be less than the minimum income. We show how an optimal investment strategy can be constructed within the setup, and discuss the advantages and disadvantages of the approach. The work presented is on based on Donnelly et al (2015,2016).