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Utility Evaluation of Risk in Retirement Saving Accounts

In: Analyses in the Economics of Aging

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  • James M. Poterba
  • Joshua Rauh
  • Steven F. Venti

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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Suggested Citation

  • James M. Poterba & Joshua Rauh & Steven F. Venti, 2005. "Utility Evaluation of Risk in Retirement Saving Accounts," NBER Chapters,in: Analyses in the Economics of Aging, pages 13-58 National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberch:10356
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    References listed on IDEAS

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    1. Bergstresser, Daniel & Poterba, James, 2004. "Asset allocation and asset location: household evidence from the survey of consumer finances," Journal of Public Economics, Elsevier, pages 1893-1915.
    2. 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.
    3. 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.
    4. 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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    6. Kapteyn, A. & Teppa, F., 2002. "Subjective Measures of Risk Aversion and Portfolio Choice," Discussion Paper 2002-11, Tilburg University, Center for Economic Research.
    7. 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.
    8. Martin Feldstein & Elena Ranguelova, 2001. "Individual Risk in an Investment-Based Social Security System," American Economic Review, American Economic Association, pages 1116-1125.
    9. Matthew Rabin, 1998. "Psychology and Economics," Journal of Economic Literature, American Economic Association, pages 11-46.
    10. Rabin, Matthew, 1997. "Fairness in Repeated Games," Department of Economics, Working Paper Series qt0nz5b4mb, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    11. Kapteyn, A. & Teppa, F., 2002. "Subjective Measures of Risk Aversion and Portfolio Choice," Discussion Paper 2002-11, Tilburg University, Center for Economic Research.
    12. 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, pages 332-382.
    13. Steven F. Venti & David A. Wise, 2001. "Choice, Chance, and Wealth Dispersion at Retirement," NBER Chapters,in: Aging Issues in the United States and Japan, pages 25-64 National Bureau of Economic Research, Inc.
    14. Steven F. Venti & David A. Wise, 2000. "Aging and Housing Equity," NBER Working Papers 7882, National Bureau of Economic Research, Inc.
    15. Robert B. Barsky & F. Thomas Juster & Miles S. Kimball & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, Oxford University Press, vol. 112(2), pages 537-579.
    16. James M. Poterba & Steven F. Venti, 1998. "Implications of Rising Personal Retirement Saving," NBER Chapters,in: Frontiers in the Economics of Aging, pages 125-172 National Bureau of Economic Research, Inc.
    17. 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.
    18. James M. Poterba, 2003. "Employer Stock and 401(k) Plans," American Economic Review, American Economic Association, pages 398-404.
    19. Matthew Rabin, 1998. "Psychology and Economics," Journal of Economic Literature, American Economic Association, pages 11-46.
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    Citations

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    Cited by:

    1. van Rooij, Maarten C.J. & Kool, Clemens J.M. & Prast, Henriette M., 2007. "Risk-return preferences in the pension domain: Are people able to choose?," Journal of Public Economics, Elsevier, pages 701-722.
    2. Johannes Binswanger, 2005. "Risk Management of Pension Systems from the Perspective of Loss Aversion," CESifo Working Paper Series 1572, CESifo Group Munich.
    3. James Poterba & Joshua Rauh & Steven Venti & David Wise, 2007. "Defined Contribution Plans, Defined Benefit Plans, and the Accumulation of Retirement Wealth," NBER Chapters,in: Public Policy and Retirement, Trans-Atlantic Public Economics Seminar (TAPES), pages 2062-2086 National Bureau of Economic Research, Inc.
    4. Brown, Jeffrey R. & Liang, Nellie & Weisbenner, Scott, 2006. "401(k) matching contributions in company stock: Costs and benefits for firms and workers," Journal of Public Economics, Elsevier, pages 1315-1346.
    5. Robert J. Willis, 2010. "Comment on "The Rise of 401(k) Plans, Lifetime Earnings, and Wealth at Retirement"," NBER Chapters,in: Research Findings in the Economics of Aging, pages 304-309 National Bureau of Economic Research, Inc.
    6. Blake, David & Cairns, Andrew & Dowd, Kevin, 2008. "Turning pension plans into pension planes: What investment strategy designers of defined contribution pension plans can learn from commercial aircraft designers," MPRA Paper 33749, University Library of Munich, Germany.
    7. Gollier, Christian, 2008. "Intergenerational risk-sharing and risk-taking of a pension fund," Journal of Public Economics, Elsevier, pages 1463-1485.
    8. Brown, Jeffrey R. & Liang, Nellie & Weisbenner, Scott, 2006. "401(k) matching contributions in company stock: Costs and benefits for firms and workers," Journal of Public Economics, Elsevier, pages 1315-1346.
    9. James M. Poterba & Joshua Rauh & Steven F. Venti & David A. Wise, 2009. "Lifecycle Asset Allocation Strategies and the Distribution of 401(k) Retirement Wealth," NBER Chapters,in: Developments in the Economics of Aging, pages 15-50 National Bureau of Economic Research, Inc.
    10. Binswanger, Johannes, 2007. "Risk management of pensions from the perspective of loss aversion," Journal of Public Economics, Elsevier, pages 641-667.
    11. James M. Poterba, 2003. "Employer Stock and 401(k) Plans," American Economic Review, American Economic Association, pages 398-404.

    More about this item

    JEL classification:

    • I0 - Health, Education, and Welfare - - General
    • H0 - Public Economics - - General

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