Toward Determining the Optimal Investment Strategy for Retirement

Abstract

Investors who are about to retire are first and foremost concerned with supporting their spending needs throughout retirement. But they also derive satisfaction from growing their wealth beyond what is needed to support consumption in order to leave a bequest to their heirs or chosen charities. The predominant metric for evaluating retirement investment strategies is the failure rate. However, it doesn’t distinguish between strategies that fail early in retirement from those that fail near the end of retirement, and it doesn’t account for potential bequests. To overcome these shortcomings the authors propose a new metric, the coverage ratio, which is more comprehensive and informative than the failure rate. In addition, they propose a utility function to evaluate the coverage ratio, which penalizes shortfalls more than it rewards surpluses. Finally, the authors use their proposed framework to determine the optimal allocation to stocks and bonds using historical and simulated returns. TOPICS: Retirement, quantitative methods, portfolio construction