Optimal investment for defined-contribution pension plans under money illusion

This paper examines the optimal asset allocation for defined-contribution pension plans in an inflationary economy under money illusion. The financial market consists of nominal bonds, inflation-linked bonds, and a stock index. The objective of the pension plan is to maximize the expected utility of a mixture of nominal and real wealth at retirement, as the plan member partially overlooks inflation and tends to think in terms of nominal rather than real monetary values. We obtain the optimal strategy and demonstrate the impacts of money illusion on asset allocation. In particular, money illusion significantly reduces investment in inflation-linked bonds. We also show that (even partially) overlooking inflation can lead to considerable welfare losses.