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1 August 2013 CFA Institute Journal Review

Defining an Individual’s Critical Wealth Level (Digest Summary)

  1. Biharilal Deora, CFA, CIPM

Traditional asset allocation models often fail to consider that individuals value both wealth and leisure time and are not always seeking wealth maximization. The author introduces critical wealth as an alternative model for individuals who have preferences in the areas of leisure time, risk tolerance, and consumption.

What’s Inside?

Most target-date funds (TDFs) assume that the asset allocation process for individuals approaching retirement is static and based on heuristics or homogeneous expectations. The author presents a utility function defining unique critical wealth and critical time horizon based on optimal consumption, leisure time, and risk tolerance preferences. Beyond critical wealth, the individual will optimize leisure time and consumption, not necessarily wealth. The critical wealth, once achieved, will determine the beginning of the glide path in TDFs, and the target wealth level determines the end.

How Is This Research Useful to Practitioners?

Traditional asset allocation models often assume individuals desire only the maximization of wealth and ignore the fact that individuals value both wealth and leisure time. The desire to maximize wealth is an appropriate assumption for institutions and entities with infinite lives but does not work for individuals because individuals may retire voluntarily before expiring their entire human capital. Analysts can use the concept of critical wealth to consider such other unique aspects of retirement as social security, taxes, inflation, long-term care, medical expenses, travel, and life expectancy.

The critical wealth level provides a theoretical basis for the reduction in allocation to risky assets. This process can reduce expected losses for individuals who are closer to retirement during a recessionary time, as shown by the varied performance of TDFs in 2008. The author emphasizes that the accumulation phase and the spending phase should be viewed differently. He presents an alternative to modern portfolio theory for individuals to help adjust glide paths for defined contribution plans, most of which are subject to unique preferences.

How Did the Author Conduct This Research?

The author begins by defining retirement as a rational decision for individuals who value leisure time in addition to consumption and wealth accumulation. That assumption is his basis for defining the individual utility model to calculate the target wealth level using annual consumption, sustainable consumption, and unique preferences. The critical wealth level is determined by setting the first derivation with respect to the wealth of the utility function equal to zero. The critical time horizon is defined as the number of working years needed for critical wealth to reach the target wealth level.

The functions provide guidance in terms of wealth levels that are less than the critical wealth, which result in individuals being concerned regarding wealth maximization versus leisure time and risk aversion in terms of absolute risk aversion. The author describes a dynamic utility function for asset allocation, which can change the allocation based on new information or major changes in an individual’s life, such as salary increases, gifts, health issues, or divorce. For a fuller understanding, the utility function model needs to be tested in different regions and timeframes to justify the results.

Abstractor’s Viewpoint

The critical wealth level is an important reference point that allows financial advisers to customize individual portfolios, offer services that cater to unique preferences, and structure logical retirement planning. More empirical studies on the model using demographic data could provide additional inputs to the process.

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