Lifetime Ruin Minimization: Should Retirees Hedge Inflation or Just Worry About It?

Inflation for retirees is different from, and mostly higher than, the widely quoted macroeconomic inflation rate for the population. For example in the U.S. the Consumer Price Index (CPI) has a lesser known cousin called the CPI-E (for the elderly) in which the subcomponent weights are based on the consumption patterns of Americans above the age of 62. This suggests that Inflation Linked Bond Funds (ILBFs) — which are based on aggregate population inflation with differing maturities — might not be the best hedge for individual retirees’ cost of living. Motivated by this question, the current paper extends lifetime ruin minimization (LRM) techniques to investigate the choice between an ILBF and a generic nominal investment fund, for a retiree facing an exogenous liability. Our model trades-off the benefits of an albeit imperfect insurance hedge against the cost of lower investment growth. And, to keep the financial economists happy, in the appendix we also solve the model by maximizing utility of lifetime consumption. Either way our numerical results suggest that ILBFs should be treated as just another asset class in the broad optimization problem, as opposed to a special or unique category.