Expected Utility andPost-Retirement Investment and

Spending Strategies

William F. Sharpe

STANCO 25 Professor of FinanceStanford University

www.wsharpe.com William F. Sharpe

Choosing a Post-retirement Financial Plan

Wealth 300

Prices 1.000 0.333 0.667 0.111 0.222 0.222 0.444Year 1 Year 2 Year 3

HH $103.37 $115.77 $124.04Now H T HH HT TH TT HT $103.37 $115.77 $103.37

TH $103.37 $93.03 $103.37TT $103.37 $93.03 $81.66

Spent Spent Spent Spent Spent Spent Spent1.00 1.12 0.90 1.20 1.00 1.00 0.79

50

60

70

80

90

100

110

120

130

Von Neumann-Morgenstern (1)

Z

0

Z

0

Z

0

W1h1

h2

h3

2

3

1

W2

W3

Von Neumann-Morgenstern (2)

Z

0

3*32*21*1 hhh

Utility

Expected Utility

)(

),...,;,...,( 11

sss

nn

XuEU

XXfEU

First-order Conditions for Maximizing Expected Utility

sss

sss

ss

sss

PPCXmu

pXu

WXpts

XuMax

)(

)('

..

)(

Marginal Utility

Single-period Utility functions

• Quadratic (Mean/Variance)

• Constant Relative Risk Aversion (CRRA)

• Hyperbolic Absolute Risk Aversion (HARA)

• Prospect theory

A Quadratic Utility Marginal Utility Function

cXbm

A Quadratic Utility Marginal Utility Function (log/log scale)

A CRRA Marginal Utility Function

bXm

A CRRA Marginal Utility Function:(log/log scale)

Xbm lnln

A HARA Marginal Utility Function(log/log scale)

)ln(ln MXbm

A Kinked Marginal Utility Function

A Kinked Marginal Utility Function(log/log scale)

Minimum level

Typical level of retirement income(Perceived loss point)

Income levels (% of pre-retirement income)

100 moveable people, one of which represents the user(experienced frequency representation of probability)

Cost

The Distribution Builder

Average Choices

Do preferences conform with maximization of a CRRA utility function?

Or do preferences exhibit loss aversion?

Types of Choices

Testing for CRRA Preferences

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0R-Squared

Distribution of R-squared Valuesfor CRRA Utility

Distribution Builder ResultsSplit at R2=0.90 (approx. median)

Multi-period Financial Plans

• Multiple time periods• For each time period, multiple possible

states of the world– mutually exclusive– exhaustive

• Objective:– Select consumption for each time and state to

maximize expected utility, subject to a budget constraint

The Simplest Possible Risky Capital Market

• Two periods– Now– Next year

• Two future states of the world– The market is up– The market is down

• Two securities– A riskless real bond– A portfolio of risky securities in market proportions

Capital Market Characteristics

Bond 1.02 u

prob = 0.50 0 1.00

prob = 0.50

1.02 d

Market Portfolio 1.18 u

prob = 0.50 0 1.00

prob = 0.50

0.94 d

Desired Spending

Spending 55.80 u

prob = 0.50 0 50.00

prob = 0.50

48.60 d

Wealth, Financial Strategy and Desired Spending

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Initial Wealth

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Bond Investment

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Market Portfolio Investment

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Wealth, Financial Strategy, Capital Markets and Spending

Initial Wealth Financial Strategy

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Capital Market Characteristics Spending

Decisions SpendingCx’= s

W B0 M0 x 100 20 30

s C 1 -1 -1 50.00 S0

0 1.02 1.18 55.80 Su0 1.02 0.94 48.60 Sd

Decisions Spending x’ = C-1s

W B0 M0 x 50.000 20.000 30.000

sC-1 1.000 0.327 0.654 0.00 S0

0.000 -3.840 4.820 55.80 Su0.000 4.167 -4.167 48.60 Sd

Arrow-Debreu Prices

W B0 M0 x 0.327 -3.840 4.167

sC-1 1.000 0.327 0.654 0.00 S0

0.000 -3.840 4.820 1.00 Su0.000 4.167 -4.167 0.00 Sd

Lockbox Strategies

21

21

11

211

1

'

'

)('

'

xxx

sCsCx

ssCx

sCx

Lockbox, Period 1

W B0 M0 x 50.000 20.000 30.000

sC-1 1.000 0.327 0.654 0.00 S0

0.000 -3.840 4.820 55.80 Su0.000 4.167 -4.167 48.60 Sd

Desired Spending: Multiple Periods

63.84uu

55.60u

53.76ud

0 50.00

52.80du

49.20 d

47.04dd

Dynamic Strategies

W B0 M0 Bu Mu Bd Md x 150.00 40.00 60.00 14.00 42.00 24.00 24.00

s C 1 -1 -1 0 0 0 0 50.00 S0

0 1.02 1.18 -1 -1 0 0 55.60 Su0 1.02 0.94 0 0 -1 -1 49.20 Sd0 0 0 1.02 1.18 0 0 63.84 Suu0 0 0 1.02 0.94 0 0 53.76 Sud0 0 0 0 0 1.02 1.18 52.80 Sdu0 0 0 0 0 1.02 0.94 47.04 Sdd

Contingent Bond Purchases

W B0 M0 Bu Mu Bd Md x 150.00 40.00 60.00 14.00 42.00 24.00 24.00

s C 1 -1 -1 0 0 0 0 50.00 S0

0 1.02 1.18 -1 -1 0 0 55.60 Su0 1.02 0.94 0 0 -1 -1 49.20 Sd0 0 0 1.02 1.18 0 0 63.84 Suu0 0 0 1.02 0.94 0 0 53.76 Sud0 0 0 0 0 1.02 1.18 52.80 Sdu0 0 0 0 0 1.02 0.94 47.04 Sdd

Contingent Market Portfolio Purchases

W B0 M0 Bu Mu Bd Md x 150.00 40.00 60.00 14.00 42.00 24.00 24.00

s C 1 -1 -1 0 0 0 0 50.00 S0

0 1.02 1.18 -1 -1 0 0 55.60 Su0 1.02 0.94 0 0 -1 -1 49.20 Sd0 0 0 1.02 1.18 0 0 63.84 Suu0 0 0 1.02 0.94 0 0 53.76 Sud0 0 0 0 0 1.02 1.18 52.80 Sdu0 0 0 0 0 1.02 0.94 47.04 Sdd

Lockbox, Period 2

% Bonds 32.89% 25.00% 50.00%W B0 M0 Bu Mu Bd Md

x 49.67 16.34 33.33 14.00 42.00 24.00 24.00

sC-1 1.000 0.327 0.654 0.107 0.214 0.214 0.427 0.00 S0

0.000 -3.840 4.820 -1.255 -2.510 1.575 3.150 0.00 Su0.000 4.167 -4.167 1.362 2.723 -1.362 -2.723 0.00 Sd0.000 0.000 0.000 -3.840 4.820 0.000 0.000 63.84 Suu0.000 0.000 0.000 4.167 -4.167 0.000 0.000 53.76 Sud0.000 0.000 0.000 0.000 0.000 -3.840 4.820 52.80 Sdu0.000 0.000 0.000 0.000 0.000 4.167 -4.167 47.04 Sdd

Lockbox Separation

• A retirement financial strategy is fully specified if spending in each year can be determined for any scenario of market returns

• A market is complete if any desired spending plan can be implemented with a retirement financial strategy

• If the market is complete, any fully specified retirement financial strategy can be implemented with a lockbox strategy

Time-separableMulti-period Utility Functions

)()()()(),,,(

)()(),(

)()(

),,,(),()(

2222

11

000

0

ddddduduududuuuuddduuduu

dduudu

ddduuduudu

susususussssEU

susussEU

susEU

ssssEUssEUsEUEU

Path-dependent Multi-period Utility Functions

)4()3()2()1(

,,:4

,,:3

,,:2

,,:1

4321

0

0

0

0

pupupupuEU

sssp

sssp

sssp

sssp

pppp

ddd

dud

udu

uuu

A Habit Formation Utility Function

)1/()()( 11 gdCXaCu g

ttt

Issac Gonzales Survey, 2009

Survey Details

Investment Market ConditionThis investment represents the case where the market goes up in year 1.

The investment provides year-2 income if the market goes up in year 1.

Total Investment Cost(current dollars, rounded to nearest

thousand)Total investment cost required to produce $81,000 of year-2 income if the market goes up in year 1.

$81,000 x $0.33 = $26,730~ $27,000

Income(current dollars, rounded to

nearest thousand)The total amount of year-2 income you will receive if the market goes up in year 1.

Investment CostFor every $0.33 that you invest today you will receive $1 in year 2 if the market goes up in year 1.

Solid vs. Dashed BordersSolid borders represents cases where the market goes up in year 1 while dashed borders represent cases where the market goes down in year 1.

Survey Example

Average Response

0.8

0.9

1

1.1

1.2

1.3

Case 0

Required Financial Strategy

N d u dd du ud uu0

0.5

1

1.5

2

2.5

3

spending

bonds

stockslg stx shrt bds

lg bds shrt stx

Implied Marginal Utility Functions

0 0.5 1 1.5 2

0.85

0.9

0.95

1

1.05

1.1

1.15

1.2

1.25

time

c

Consumption versus time

-0.2 -0.1 0 0.1 0.2 0.3-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

log(c)

loc(

ppc)

log(PPC) versus log(c)

gu=2.59

gd=2.79

g1=2.70

v1

v2

d=v1/v2 = -0.82

d Values

Unanswered Questions

• How can we determine an individual’s true preferences?

• Are individual choices consistent with axioms of “rational decisions”?

• How can the influence of framing be minimized?

• How can an optimal financial strategy for complex preferences be determined?

The Fidelity Income Replacement Funds

• Horizon date– E.g. 2036

• Investment strategy– Time-dependent “glide path” asset allocation

• Spending Rule– Pre-specified time-dependent proportions of

asset value

Spending Rule

Annual Target Payment Rates

0

10

20

30

40

50

60

70

80

90

100

30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1

Years to Horizon

Per

ent

of

Fu

nd

Sp

ent

Investment Strategy

Lockbox Equivalence

• Any strategy with a time-dependent proportional spending rule and a time-dependent investment strategy is equivalent to a lockbox strategy

• Each lockbox will have the same investment strategy and

• The initial amounts to be invested in the lockboxes can be computed from the pre-specified spending rates

Initial Lockbox Values (1)

• Let:kt = the proportion spent in year t

Rt = the total return on investment in year t (e.g. 1.02 for 2%)

• The amounts spent in the first three years will be:

Wk0

(1-k0)WR1k1

(1-k0)WR1(1-k1) R2k2

Initial Lockbox Values (2)

• Re-arranging:{Wk0}

{W(1-k0)k1} R1

{W(1-k0)(1-k1)k2} R1R2

• But these are the ending values for lockboxes with the initial investments shown in the brackets { }– therefore, investing these amounts in lockboxes will give

the same spending plan as the original strategy

Percentages of Initial Wealth in Lockboxes

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Lockbox Year

Per

cen

t o

f In

itia

l W

ealt

h W

ealt

h

A Simple Income Replacement Fund

• Two assets– A riskless real bond– A market portfolio

• (e.g. 60% Stocks, 40% Bonds)

• A glide path similar to that for equity funds in the Fidelity Income Replacement Funds

• A 30-year horizon• Annual payment rates equal to those of

the Fidelity Income Replacement Funds

Capital Market Characteristics

• Riskless real return– 2 % per year

• Market portfolio real return– Lognormally distributed each year– Expected annual return

• 6 % per year

– Annual standard deviation of return• 12 % per year

– No serial correlation

Monte Carlo Simulations

• 10,000 scenarios of 29 years each

• Returns for each lockbox are simulated

• State prices for payment in year 29 are assumed to be log-linearly related to cumulative market returns– Consistent with a CRRA pricing kernel– Consistent with limit of a binomial i.i.d. return-

generating process

Year 29: State Prices and Spending

0 0.5 1 1.5 2 2.5 3 3.5 4-18

-16

-14

-12

-10

-8

-6

-4

-2

log(Spending)

log(

Sta

te P

rice)

log(State Prices) and log(Spending), Year 29

Year 29: Cumulative Market Return and Spending

-2 -1 0 1 2 3 40

0.5

1

1.5

2

2.5

3

3.5

4

Log(CumRms)

Log(

Spe

ndin

g)

Log(Spending) and log(Cumulative Returns on Market)

Real-world Challenges

• Determining each individual’s true preferences

• Determining the return generating process

• Representing capital market instruments

• Estimating the feasibility of dynamic strategies

• Incorporating annuities

• Insuring the macro-consistency of optimal strategies