Hostname: page-component-848d4c4894-pjpqr Total loading time: 0 Render date: 2024-06-16T16:43:52.440Z Has data issue: false hasContentIssue false
  • English
  • Français

The Design and Welfare Implications of Mandatory Pension Plans

Published online by Cambridge University Press:  16 January 2023

Linda S. Larsen  and
Claus Munk Open the ORCID record for Claus Munk [Opens in a new window]
Linda S. Larsen
Affiliation:
Copenhagen Business School Department of Finance, Pension Research Centre (PeRCent), and Danish Finance Institute lsl.fi@cbs.dk
Claus Munk*
Affiliation:
Copenhagen Business School Department of Finance, Pension Research Centre (PeRCent), and Danish Finance Institute
*
cm.fi@cbs.dk (corresponding author)
Get access Rights & Permissions [Opens in a new window]

Abstract

In a rich, calibrated life-cycle model, we show that well-designed mandatory pension plans significantly improve the welfare of individuals procrastinating on savings, and even improve most rational individuals’ welfare through a return tax advantage and fair annuitization. For a group of heterogeneous savers, in terms of preferences and sophistication, the best plan has contributions of 10% of income from age 30, a glidepath investment strategy, payouts following a variable lifelong annuity, and options to choose a different investment strategy and to modify the annuitization feature. This plan generates an average welfare gain of $175,000 per individual.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 8 , December 2023 , pp. 3420 - 3449
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

We appreciate comments and suggestions from an anonymous referee, Marcel Fischer, Thierry Foucault (the editor), Bjarne Astrup Jensen, Bruno Kamden, Matti Keloharju, David Laibson, Ellen McGrattan, Alexander Michaelides, Lasse Heje Pedersen, Jesper Rangvid, and Roine Vestman, and participants at presentations at the 2019 PeRCent Conference in Copenhagen, the City University of Hong Kong, Aalto University Helsinki, the Danish Society of Actuaries, Lund University, the 2020 FMA Virtual Conference, and the European University Institute and Banco de España’s 2021 Conference on Social Security Reforms. We gratefully acknowledge support from the Danish Finance Institute (DFI) and from PeRCent, which receives base funding from the Danish pension funds and Copenhagen Business School.

References

Arias, E., and Xu, J.. “United States Life Tables, 2017.” National Vital Statistics Reports, 68 (2019), 1–66.Google Scholar
Barber, B. M., and Odean, T.. “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” Journal of Finance, 55 (2000), 773–806.Google Scholar
Benartzi, S., and Thaler, R. H.. “Heuristics and Biases in Retirement Savings Behavior.” Journal of Economic Perspectives, 21 (2007), 81–104.Google Scholar
Benzoni, L.; Collin-Dufresne, P.; and Goldstein, R. S.. “Portfolio Choice over the Life-Cycle when the Stock and Labor Markets Are Cointegrated.” Journal of Finance, 62 (2007), 2123–2167.Google Scholar
Bernheim, B. D.; Skinner, J.; and Weinberg, S.. “What Accounts for the Variation in Retirement Wealth Among U.S. Households?” American Economic Review, 91 (2001), 832–857.Google Scholar
Beshears, J.; Choi, J. J.; Laibson, D.; and Madrian, B. C.. “Behavioral Household Finance.” In Handbook of Behavioral Economics: Foundations and Applications, Chap. 3, Bernheim, B. D., DellaVigna, S., and Laibson, D., eds. Amsterdam, The Netherlands: Elsevier (2018), 177–276.Google Scholar
Bhamra, H. S., and Uppal, R.. “Does Household Finance Matter? Small Financial Errors with Large Social Costs.” American Economic Review, 109 (2019), 1116–1154.Google Scholar
Blake, D.; Wright, D.; and Zhang, Y.. “Age-Dependent Investing: Optimal Funding and Investment Strategies in Defined Contribution Pension Plans when Members Are Rational Life Cycle Financial Planners.” Journal of Economic Dynamics and Control, 38 (2014), 105–124.Google Scholar
Bodie, Z.; Merton, R. C.; and Samuelson, W. F.. “Labor Supply Flexibility and Portfolio Choice in a Life Cycle Model.” Journal of Economic Dynamics and Control, 16 (1992), 427–449.Google Scholar
Bonaparte, Y., and Fabozzi, F. J.. “Estimating the Elasticity of Intertemporal Substitution Accounting for Stockholder-Specific Portfolios.” Applied Economics Letters, 24 (2017), 923–927.Google Scholar
Branger, N.; Larsen, L. S.; and Munk, C.. “Hedging Recessions.” Journal of Economic Dynamics and Control, 107 (2019), Article no. 103715.Google Scholar
Bricker, J.; Dettling, L. J.; Henriques, A.; Hsu, J. W.; Jacobs, L.; Moore, K. B.; Pack, S.; Sabelhaus, J.; Thompson, J.; and Windle, R. A.. “Changes in U.S. Family Finances from 2013 to 2016: Evidence from the Survey of Consumer Finances.” Federal Reserve Bulletin, 103 (2017), 1–42.Google Scholar
Brown, J. R., and Previtero, A.. “Saving for Retirement, Annuities, and Procrastination.” Working Paper, University of Illinois and Indiana University, available at http://www.aleprevitero.com/ (2020).Google Scholar
Calvet, L. E.; Campbell, J. Y.; Gomes, F. J.; and Sodini, P.. “The Cross-Section of Household Preferences.” Working Paper, Harvard University, available at https://scholar.harvard.edu/campbell (2021).Google Scholar
Calvet, L. E.; Campbell, J. Y.; and Sodini, P.. “Down or Out: Assessing the Welfare Costs of Household Investment Mistakes.” Journal of Political Economy, 115 (2007), 707–747.Google Scholar
Campbell, J. Y. “Household Finance.” Journal of Finance, 61 (2006), 1553–1604.Google Scholar
Campbell, J. Y. “Restoring Rational Choice: The Challenge of Consumer Financial Regulation.” American Economic Review, 106 (2016), 1–30.Google Scholar
Campbell, J. Y.; Cocco, J. F.; Gomes, F.; and Maenhout, P. J.. “Investing Retirement Wealth: A Life-Cycle Model.” In Risk Aspects of Investment-Based Social Security Reform, Chap. 5, Campbell, J. Y. and Feldstein, M., eds. Chicago, IL: University of Chicago Press (2001), 439–473.Google Scholar
Charupat, N., and Milevsky, M. A.. “Optimal Asset Allocation in Life Annuities: A Note.” Insurance: Mathematics and Economics, 30 (2002), 199–209.Google Scholar
Chiappori, P.-A., and Paiella, M.. “Relative Risk Aversion Is Constant: Evidence from Panel Data.” Journal of the European Economic Association, 9 (2011), 1021–1052.Google Scholar
Choi, J. J.; Laibson, D.; and Madrian, B. C.. “$100 Bills on the Sidewalk: Suboptimal Investment in 401(K) Plans.” Review of Economics and Statistics, 93 (2011), 748–763.Google Scholar
Choi, J. J.; Laibson, D.; Madrian, B. C.; and Metrick, A.. “Defined Contribution Pensions: Plan Rules, Participant Choices, and the Path of Least Resistance.” Tax Policy and the Economy, 16 (2002), 67–113.Google Scholar
Cocco, J. F. “Portfolio Choice in the Presence of Housing.” Review of Financial Studies, 18 (2005), 535–567.Google Scholar
Cocco, J. F.; Gomes, F. J.; and Maenhout, P. J.. “Consumption and Portfolio Choice over the Life Cycle.” Review of Financial Studies, 18 (2005), 491–533.Google Scholar
Dahlquist, M.; Setty, O.; and Vestman, R.. “On the Asset Allocation of a Default Pension Fund.” Journal of Finance, 73 (2018), 1893–1936.Google Scholar
Dammon, R. M.; Spatt, C. S.; and Zhang, H. H.. “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing.” Journal of Finance, 59 (2004), 999–1037.Google Scholar
Davidoff, T.; Brown, J. R.; and Diamond, P.. “Annuities and Individual Welfare.” American Economic Review, 95 (2005), 1573–1590.Google Scholar
Davis, S. J., and Willen, P.. “Using Financial Assets to Hedge Labor Income Risks: Estimating the Benefits.” Working Paper, University of Chicago and Princeton University (2000).Google Scholar
De Nardi, M.; French, E.; and Jones, J. B.. “Why Do the Elderly Save? The Role of Medical Expenses.” Journal of Political Economy, 118 (2010), 39–75.Google Scholar
De Nardi, M.; French, E.; Jones, J. B.; and McCauley, J.. “Medical Spending of the US Elderly.” Fiscal Studies, 37 (2016), 717–747.Google Scholar
Fagereng, A.; Gottlieb, C.; and Guiso, L.. “Asset Market Participation and Portfolio Choice over the Life-Cycle.” Journal of Finance, 72 (2017), 705–750.Google Scholar
Fischer, M., and Gallmeyer, M. F.. “Taxable and Tax-Deferred Investing with the Limited Use of Losses.” Review of Finance, 21 (2017), 1847–1873.Google Scholar
Ghilarducci, T., and James, T.. Rescuing Retirement: A Plan to Guarantee Retirement Security for All Americans. New York, NY: Columbia Business School Publishing (2018).Google Scholar
Gomes, F.; Hoyem, K.; Hu, W.-Y.; and Ravina, E.. “Retirement Savings Adequacy in U.S. Defined Contribution Plans.” Available at SSRN: http://ssrn.com/abstract=3294422 (2020).Google Scholar
Gomes, F., and Michaelides, A.. “Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labor Income Risk.” Review of Economic Dynamics, 6 (2003), 729–766.Google Scholar
Gomes, F., and Michaelides, A.. “Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence.” Journal of Finance, 60 (2005), 869–904.Google Scholar
Gomes, F.; Michaelides, A.; and Polkovnichenko, V.. “Optimal Savings with Taxable and Tax-Deferred Accounts.” Review of Economic Dynamics, 12 (2009), 718–735.Google Scholar
Gourinchas, P.-O., and Parker, J. A.. “Consumption over the Life Cycle.” Econometrica, 70 (2002), 47–89.Google Scholar
Guiso, L., and Sodini, P.. “Household Finance: An Emerging Field.” In Handbook of the Economics of Finance, Chap. 21, Constantinides, G. M., Harris, M., and Stulz, R. M., eds. Amsterdam, The Netherlands: Elsevier (2013), 1397–1532.Google Scholar
Guvenen, F.; Karahan, F.; Ozkan, S.; and Song, J.. “What Do Data on Millions of U.S. Workers Reveal About Lifecycle Earnings Dynamics?” Econometrica, 89 (2021), 2303–2339.Google Scholar
Heimer, R. Z.; Myrseth, K. O. R.; and Schoenle, R. S.. “YOLO: Mortality Beliefs and Household Finance Puzzles.” Journal of Finance, 74 (2019), 2957–2996.Google Scholar
Horneff, W. J.; Maurer, R. H.; Mitchell, O. S.; and Stamos, M. Z.. “Variable Payout Annuities and Dynamic Portfolio Choice in Retirement.” Journal of Pension Economics and Finance, 9 (2010), 163–183.Google Scholar
Inkmann, J.; Lopes, P.; and Michaelides, A.. “How Deep Is the Annuity Market Participation Puzzle?” Review of Financial Studies, 24 (2011), 279–319.Google Scholar
Klingsieck, K. B. “Procrastination—When Good Things Don’t Come to Those Who Wait.” European Psychologist, 18 (2013), 24–34.Google Scholar
Koijen, R. S. J.; Nijman, T. E.; and Werker, B. J. M.. “When Can Life-Cycle Investors Benefit from Time-Varying Bond Risk Premia?” Review of Financial Studies, 23 (2010), 741–780.Google Scholar
Koijen, R. S. J.; Nijman, T. E.; and Werker, B. J. M.. “Optimal Annuity Risk Management.” Review of Finance, 15 (2011), 799–833.Google Scholar
Koijen, R. S. J.; van Nieuwerburgh, S.; and Yogo, M.. “Health and Mortality Delta: Assessing the Welfare Cost of Household Insurance Choice.” Journal of Finance, 71 (2016), 957–1010.Google Scholar
Laibson, D. “Golden Eggs and Hyperbolic Discounting.” Quarterly Journal of Economics, 112 (1997), 443–477.Google Scholar
Lockwood, L. M. “Bequest Motives and the Annuity Puzzle.” Review of Economic Dynamics, 15 (2012), 226–243.Google Scholar
Mitchell, O. S.; Poterba, J. M.; Warshawsky, M. J.; and Brown, J. R.. “New Evidence on the Money’s Worth of Individual Annuities.” American Economic Review, 89 (1999), 1299–1318.Google Scholar
Paravisini, D.; Rappoport, V.; and Ravina, E.. “Risk Aversion and Wealth: Evidence from Person-to-Person Lending Portfolios.” Management Science, 63 (2017), 279–297.Google Scholar
Schlafmann, K.; Setty, O.; and Vestman, R.. “Optimal Defined Contribution Pension Plans: One-Size Does Not Fit All.” Discussion paper 8-2020, The Pinhas Sapir Center for Development, Tel Aviv University (2020).Google Scholar
Steel, P. “The Nature of Procrastination.” Psychological Bulletin, 133 (2007), 65–94.Google Scholar
Thurow, L. “The Optimum Lifetime Distribution of Consumption Expenditures.” American Economic Review, 59 (1969), 324–330.Google Scholar
Viceira, L. M. “Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income.” Journal of Finance, 56 (2001), 433–470.Google Scholar
Vissing-Jørgensen, A. “Limited Asset Market Participation and the Elasticity of Intertemporal Substitution.” Journal of Political Economy, 110 (2002), 825–853.Google Scholar
Yaari, M. “Uncertain Lifetime, Life Insurance, and the Thoery of the Consumer.” Review of Economic Studies, 32 (1965), 137–150.Google Scholar
Yogo, M. “Portfolio Choice in Retirement: Health Risk and the Demand for Annuities, Housing, and Risky Assets.” Journal of Monetary Economics, 80 (2016), 17–34.Google Scholar
Supplementary material: PDF

Larsen and Munk supplementary material

Internet Appendix

Download Larsen and Munk supplementary material(PDF)
PDF 342.4 KB