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Analyses in the Economics of Aging

The University of Chicago Press

Contents

Preface..................................................................................................................................................................................................ixIntroduction David A. Wise..............................................................................................................................................................................11. Utility Evaluation of Risk in Retirement Saving Accounts James M. Poterba, Joshua Rauh, Steven F. Venti, and David A. Wise..........................................................................132. Passive Decisions and Potent Defaults James J. Choi, David Laibson, Brigitte C. Madrian, and Andrew Metrick.........................................................................................593. Characterizing the Experiences of High-Cost Users in Medicare Thomas MaCurdy and Jeff Geppert.......................................................................................................794. The Efficiency of Medicare Jonathan Skinner, Elliott S. Fisher, and John E. Wennberg................................................................................................................1295. Intensive Medical Technology and the Reduction in Disability David M. Cutler........................................................................................................................1616. Broken Down by Work and Sex: How Our Health Declines Anne Case and Angus Deaton.....................................................................................................................1857. Consequences and Predictors of New Health Events James P. Smith.....................................................................................................................................2138. Healthy, Wealthy, and Knowing Where to Live: Trajectories of Health, Wealth, and Living Arrangements among the Oldest Old Florian Heiss, Michael D. Hurd, and Axel Brsch-Supan.....................2419. Institutions and Saving for Retirement: Comparing the United States, Italy, and the Netherlands Arie Kapteyn and Constantijn Panis..................................................................28110. Household Saving in Germany: Results of the First SAVE Study Axel Brsch-Supan and Lothar Essig.....................................................................................................31711. Caste, Culture, and the Status and Well-Being of Widows in India Robert Jensen......................................................................................................................35712. Individual Subjective Survival Curves Li Gan, Michael D. Hurd, and Daniel McFadden..................................................................................................................377Contributors.............................................................................................................................................................................................413Author Index.............................................................................................................................................................................................417Subject Index............................................................................................................................................................................................421

Chapter One

The last two decades have witnessed a remarkable shift in the structure of retirement saving in the United States. In 1980, most workers with pension plans participated in defined benefit plans, with benefits determined by the worker's earnings history, years of service, and age at the time of retirement. The investment allocation of assets in defined benefit pension accounts was determined by professional money managers or corporate executives, and the worker controlled his retirement benefit only through the choice of retirement age and job change decisions.

Over the 1980s and 1990s, the U.S. pension system shifted toward a defined contribution structure, with 401(k) plans growing particularly rapidly. In the late 1990s, about 85 percent of pension plan contributions were directed to defined contribution personal retirement accounts. This shift transferred responsibility for investment decisions, contribution rates, and ultimately the draw-down of retirement assets from firms to workers. It replaced the link between retirement income, job change, and final earnings, which were important sources of worker risk, with a link between retirement account balances and the uncertain return on invested assets. The risk that workers bear as a result of fluctuations in the value of assets in retirement accounts has attracted considerable attention in the popular press, often with the claim that workers are now facing riskier retirement prospects than in the past.

This paper presents new evidence on the risk of different investment strategies when evaluated in terms of retirement wealth accumulation. We use two different approaches to describe the risk of investing 401(k) assets in a broadly diversified portfolio of common stocks, compared to a portfolio of index bonds. The first involves computing the empirical distribution of potential wealth values at retirement resulting from different investment strategies, and then making explicit comparisons of the wealth distributions. If the average return on one asset class, such as corporate stock, is substantially greater than the average return on another asset class, such as bonds, this approach shows that over long horizons, the higher-return asset class will outperform the lower-return asset class with very high probability. One criticism of this approach is that it does not adequately consider the potential cost to a retiree of the low levels of wealth at retirement that might emerge from the riskier, but higher-expected-return, strategy.

Our second evaluation approach is designed to address this issue. We assume that the value that the retiree assigns to the consumption stream after retirement can be parameterized using a simple utility function, in which utility is a function of the stock of wealth at retirement. We then use simulation methods to compute the distribution of wealth at retirement that might emerge under different portfolio investment strategies, and to evaluate the expected utility of this distribution. Comparing the expected utility, which recognizes the potential cost of a small probability of very unfavorable outcomes, provides an alternative to comparing the distributions as a method for evaluating different investment strategies.

We compare the distribution of retirement wealth and the expected utility of retirement wealth for three different investment strategies. The first involves holding only index bonds, the second holds only a portfolio of common stocks similar to the Standard & Poor 500 index (S&P 500), and the third invests in a fifty-fifty mix of index bonds and common stocks. We conduct our analysis at the household level, recognizing that retirement plan investment decisions have implications for all household members. We also treat the evaluation of risk as a collective household decision. To make the retirement wealth calculations as realistic as...