Stochastic lifestyling: Optimal dynamic asset allocation for defined contribution pension plans

We investigate asset-allocation strategies open to members of defined-contribution pension plans with a model that incorporates asset, salary (labour-income) and interest-rate risk. We propose a novel form of terminal utility function, incorporating habit formation, that uses the member's final salary as a numeraire. The paper discusses various properties and characteristics of the optimal asset-allocation strategy both with and without the presence of non-hedgeable salary risk. Finally, we compare the performance of the optimal strategy with some popular alternatives used by pension providers and we conclude that it significantly enhances the welfare of a wide range of potential plan members relative to these other strategies.