Market Risk, Mortality Risk, and Sustainable Retirement Asset Allocation: A Downside Risk Perspective

Despite its clear importance, there is no consensus on the optimal asset allocation strategy for retirement investors of varying age, gender, and risk tolerance. This study analyzes the allocation question by focusing on the downside risks that result from the joint uncertainty over investment returns and life expectancy. Using a new analytical approach, we show that concentrating on the severity of retirement funding shortfalls, rather than just the probability of ruin, markedly increases the sustainability of a retirement portfolio. We demonstrate that for retirement investors attempting to minimize downside risk while sustaining future withdrawals, appropriate equity allocations range between five and 25 percent, levels that are strikingly low compared to those typically found in life-cycle funds. Further, these optimal portfolio constructions appear to vary little with alternative capital market assumptions. We also show that more aggressive investors having substantial bequest motives should still be relatively conservative in their stock allocations. We conclude that the higher equity allocations commonly employed in practice significantly underestimate the risks that these highervolatility portfolios pose to the sustainability of retirement savings and incomes. JEL Classification: G11, G17