Working Paper: CEPR ID: DP13019
Authors: Francisco J. Gomes; Alexander Michaelides; Yuxin Zhang
Abstract: We show that saving for retirement in target date funds (TDFs) modified to take advantage of predictability in excess returns driven by the variance risk premium generates economically large welfare gains. We call these funds tactical target date funds (TTDFs). To be easily implementable and communicated to investors, the portfolio rule followed by TTDFs is designed to be extremely simplified relative to the optimal policy rules. Despite this significant mis-specification, substantial welfare gains persist. Importantly, these gains remain economically important even after we introduce restrictions that limit turnover to empirically observed magnitudes for mutual funds, and after we take into account potential increases in transaction costs. Crucially, we show that this predictability is not correlated with individual household risk, confirming that households are in a prime position to exploitthis premium.
Keywords: target date funds; life cycle portfolio choice; retirement savings; variance risk premium; strategic asset allocation; tactical asset allocation; market timing
JEL Codes: G11; D14; D15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| variance risk premium (VRP) predictability (G17) | expected returns (G17) |
| variance risk premium (VRP) predictability (G17) | retirement savings through tactical target date funds (TTDFs) (G23) |
| modification of TDFs to exploit VRP predictability (C69) | higher wealth accumulation at retirement (G51) |
| tactical target date funds (TTDFs) (G23) | certainty equivalent consumption gains (D11) |
| tactical target date funds (TTDFs) (G23) | significant welfare improvements for households (H53) |
| high realizations of the variance risk premium (VRP) (G17) | household consumption growth (D10) |