**DISCUSSION PAPER PI-0815**

Optimal asset allocation strategy for defined-contribution pension plans
with power

utility

Qing-Ping Ma

Optimal asset allocation strategies of defined-contribution pension plans
for members

whose terminal utility is a power function of wealth-to-wage ratio is investigated
in

this paper. The portfolio problem is to maximize the expected terminal utility
in the

presence of three risk sources, interest risk, asset risk and wage risk. A
closed form

solution is found for the asset allocation problem and the optimal portfolio

composition is horizon independent when there is no non-hedgeable wage risk
or

there is no further contribution from wage incomes. When future contributions
from

wage income are hedged by short-selling a wage replicating portfolio, the
optimal

composition of financial wealth on hand (i.e. pension portfolio wealth + short-sold

wage replicating portfolio) is horizon-dependent. The optimal asset allocation
strategy

is equivalent to invest in two mutual funds, one of which is to hedge wage
risk and the

other a speculative fund to satisfy the risk appetite of the plan member.

Keywords : Defined-contribution pension plan; Wage risk; Optimal asset allocation;

Power utility; Hamilton-Jacobi-Bellman equation