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Utility Evaluation of Risk in Retirement Saving Accounts

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  • James Poterba
  • Joshua Rauh
  • Steven Venti
  • David Wise

Abstract

The shift from defined benefit to defined contribution plans in the United States has drawn new attention to the effect of participants' asset allocation decisions on their financial resources for retirement. This paper develops a stochastic simulation algorithm to evaluate the effect of holding a broadly diversified portfolio of common stocks, or a portfolio of index bonds, on the distribution of 401(k) account balances at retirement. We compare the alternative distributions of retirement wealth both by showing the empirical distribution of potential wealth values, and by computing the expected utility of these outcomes under standard assumptions about the structure of household preferences. Our analysis highlights the critical role of other sources of wealth, such as Social Security, defined benefit pension annuities, and saving outside retirement plans in determining the expected utility cost of holding equities in the retirement account. Our findings also demonstrate the importance of the equity premium in affecting investors' utility from different retirement asset allocations. Viewed from the beginning of a working career, and given the historical pattern of returns on stocks and bonds, a household that does not have extremely high risk aversion would achieve a higher expected utility by holding a portfolio of stocks rather than bonds.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9892.

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Date of creation: Aug 2003
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Publication status: published as Utility Evaluation of Risk in Retirement Saving Accounts , James M. Poterba, Joshua Rauh, Steven F. Venti. in Analyses in the Economics of Aging , Wise. 2005
Handle: RePEc:nbr:nberwo:9892

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  1. Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
  2. Alicia H. Munnell & Annika Sunden, 2002. "401(k)s And Company Stock: How Can We Encourage Diversification?," Issues in Brief ib-9, Center for Retirement Research.
  3. James M. Poterba & Steven F. Venti, 2004. "The Transition to Personal Accounts and Increasing Retirement Wealth: Macro- and Microevidence," NBER Chapters, in: Perspectives on the Economics of Aging, pages 17-80 National Bureau of Economic Research, Inc.
  4. Arie Kapteyn & Federica Teppa, 2002. "Subjective Measures of Risk Aversion and Portfolio Choice," Working Papers 02-03, RAND Corporation Publications Department.
  5. James M. Poterba, 2003. "Employer Stock and 401(k) Plans," American Economic Review, American Economic Association, vol. 93(2), pages 398-404, May.
  6. Martin Feldstein & Elena Ranguelova, 2001. "Individual Risk in an Investment-Based Social Security System," NBER Working Papers 8074, National Bureau of Economic Research, Inc.
  7. Rabin, Matthew, 1997. "Psychology and Economics," Department of Economics, Working Paper Series qt8jd5z5j2, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  8. James M. Poterba & Steven F. Venti & David A. Wise, 1999. "Implications of Rising Personal Retirement Saving," NBER Working Papers 6295, National Bureau of Economic Research, Inc.
  9. Daniel Bergstresser & James Poterba, 2002. "Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances," NBER Working Papers 9268, National Bureau of Economic Research, Inc.
  10. Steven F. Venti & David A. Wise, 2000. "Choice, Chance, and Wealth Dispersion at Retirement," NBER Working Papers 7521, National Bureau of Economic Research, Inc.
  11. Olivia S. Mitchell & Stephen P. Utkus, 2002. "The Role of Company Stock in Defined Contribution Plans," NBER Working Papers 9250, National Bureau of Economic Research, Inc.
  12. Steven F. Venti & David A. Wise, 2000. "Aging and Housing Equity," NBER Working Papers 7882, National Bureau of Economic Research, Inc.
  13. Andrew A. Samwick & Jonathan Skinner, 1998. "How Will Defined Contribution Pension Plans Affect Retirement Income?," NBER Working Papers 6645, National Bureau of Economic Research, Inc.
  14. Ranguelova, Elena & Feldstein, Martin, 2001. "Individual Risk in an Investment-Based Social Security System," Scholarly Articles 2797440, Harvard University Department of Economics.
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