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, also called the wealth distribution stage of the life-cycle, as new sources of income are typically not available to individuals. Utilizing a multi-stage stochastic program, we 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, we find optimal policies assuming no longevity risk (i.e., lifetime scenarios are uncertain although life expectancy is fixed on the retirement date). Next, we introduce longevity risk in the scenario generation stage through either a shift in the expected lifetimes or an unexpected cut in periodic retirement income. We find that optimal asset allocation policy depends on the presence and the type of these risks as well as the relative price of insurance and the percentage cut in pension benefits.