Alternative Strategies to Hedge Longevity Risk in Defined Contribution Pension Plans for Loss-Averse Individuals

This study aims to determine the optimal investment strategy in defined contribution pension plans by extending beyond the traditional expected utility maximisation framework, and explicitly modelling investor behaviour under loss aversion to capture more realistic decision-making dynamics. While determining the optimal investment strategy for loss-averse individuals, the longevity risk arising from the decrease in mortality probabilities observed all over the world in recent years should also be considered. Accordingly, the optimal investment strategy for loss-averse individuals is derived by incorporatinglongevity risk into the model and employingstochastic dynamic programming as the optimisation technique. The results indicate that a loss-averse individual should follow a more aggressive investment strategy in the accumulation period to hedge longevity risk during the distribution period. Given that loss-averse individuals are generally reluctant to engage in riskier investment strategies, this study explores alternative methods to hedge longevity risk. From the results obtained, it is concluded that determiningthe appropriate contribution rate and the appropriate minimum fund guarantee for the loss-averse individuals reduces the risk in the optimal investment strategy. These findings underscore the importance of tailoring investment strategies in defined contribution pension plans to align with individual risk preferences and the financial challenges posed by increasing life expectancy.