Utility Evaluation of Risk in Retirement Saving Accounts

James Poterba, Massachusetts Institute of Technology and National Bureau of Economic Research
Joshua Rauh, Massachusetts Institute of Technology
Steven Venti, Dartmouth College and National Bureau of Economic Research
David Wise, National Bureau of Economic Research and Harvard University

The shift from defined benefit to defined contribution plans in the United States has drawn 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 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. Our analysis highlights the critical role of other sources of wealth, such as Social Security, defined benefit pensions, 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.