Optimal DC Pension Fund Management and the Dangers of Longevity Risk

There is a pressing need to re-design the defined contribution pension scheme so that it can become an adequate replacement for the failing defined benefit scheme. This paper focuses on the importance of accounting for systematic longevity risk in light of this assertion. We discuss a proposed, plan member oriented, pension plan design that aims to deliver a desired standard of living in retirement through the use of the replacement ratio in the objective function of the optimal portfolio choice problem. We introduce an analytically tractable stochastic mortality model in order to facilitate working within a continuous-time dynamic programming framework. In order to gauge the impact of longevity risk we introduce, into the asset mix of the portfolio choice problem, a synthetic longevity-linked security. We determine the relative demand for this asset, and the value added through the introduction of this asset in terms of a utility gain. We find that for sufficiently risk averse plan members the value added by way of a reduction in conditional volatility is substantial, however these effects can be drowned out if the proportion of pension fund wealth allocated to risky assets is large. EFM Classification: 370, 770