Abstract
This article presents a comprehensive, dynamic asset allocation framework for retirement savings, extending the classical Merton model to include human capital. This framework reconciles the intuitive age-based glide path with financial theory, recognizing that total wealth consists of financial capital and the present value of future contributions. It shows that the optimal allocation of risky assets depends on the ratio of human to financial capital, risk aversion, investment horizon, and key market parameters, such as the risk premium and volatility. Under CRRA utility, closed form solutions are derived, demonstrating that continuous contributions increase risk exposure relative to the constant-mix strategy. The article also compares glide path strategies with constant mix approaches, revealing that glide paths generally provide better downside protection and higher probabilities of meeting retirement goals, while dynamically adjusting risk exposure over time. The analysis further examines the shape of the glide path and shows that practical constraints, such as leverage limits, time-varying risk aversion, and rising contribution patterns, transform the theoretically convex allocation path into the empirically observed concave form.
The article expands the model to include multiple asset classes, providing a deep analysis of the practical differences between single-asset and multi-asset approaches. It emphasizes how allocation constraints, such as long-only requirements, leverage limits, and maximum exposure caps, impact optimal portfolio construction. The analysis shows that incorporating multiple asset classes yields greater diversification benefits, thereby enhancing risk-adjusted returns and improving retirement savings outcomes. Including real assets, such as private equity, private debt, real estate, and infrastructure, is valuable due to their unique risk-return profiles and lower correlations with traditional public equities and bonds. The framework acknowledges the practical challenges posed by liquidity risk and transaction costs, recognizing that real assets typically operate in markets with investment frictions during ramp-up and run-off phases when capital is deployed or withdrawn. It incorporates a time-varying liquidity weight that adjusts the portfolio’s exposure to illiquid assets dynamically over the investment horizon. This mechanism reflects the natural lifecycle of investments. Younger investors can tolerate more illiquid investments for their potentially higher returns, while those approaching retirement gradually shift toward more liquid assets to ensure accessibility when needed.
Recognizing that inflation risk is a critical concern for retirement planning since inflation erodes the real purchasing power of accumulated wealth, the framework explicitly incorporates inflation dynamics and inflation-sensitive assets. By modeling inflation as a stochastic process and introducing assets whose returns are linked to inflation, the optimal allocation naturally decomposes into two components: a growth oriented market portfolio and a liability-hedging portfolio designed to protect against inflation risk. This decomposition aligns d fined contribution strategies with liability driven investment principles used by defined benefit plans, ensuring that portfolios grow nominal wealth and preserve real value over time. From this perspective, assets serve as performance drivers and hedges against inflation risk. This underscores the importance of including inflation-sensitive assets, such as real assets.
Authors
