Optimal Longevity Risk Management in the Retirement Stage of the Life Cycle

Abstract

The uncertainty in life expectancy plays a critical role in individual financial planning. Its impact is magnified during the retirement years (the wealth distribution stage of the life cycle), as new sources of income typically are not available to retired persons. Utilizing a multi-stage stochastic program, the authors model and solve the optimal asset allocation problem of a retired couple with uncertain life expectancy in the presence of a term life insurance policy. In the base case, they find optimal policies assuming no longevity risk (i.e., lifetime scenarios are uncertain although life expectancy is fixed on the retirement date). Next, they introduce longevity risk in the scenario generation stage through either a shift in the expected lifetimes or an unexpected cut in periodic retirement income. The authors find that the optimal asset allocation policy depends on the presence and the type of these risks as well as the relative price of insurance and the size of any cut in pension benefits.