The Demand for Guarantees in Social Security Personal Retirement Accounts
This project evaluates how workers might invest their Personal Retirement Account (PRA) funds between safe and risky assets, depending on whether they are offered a rate of return guarantee on the risky asset. We focus on how asset allocation decisions might differ depending on participants’ attitudes about risk and regret. If, for example, the return on the risky asset turns out to be very high when a worker retires, he might regret not having allocated a large enough portion of his contributions to the risky asset. On the contrary, if the stock market does poorly, the retiree might regret having invested at all in that asset. We show that anticipated disutility from regret can have a potent effect on investment choices in a PRA. If there is no guarantee, regret induces investors to move away from extreme decisions: that is, investors who take regret into account hold less stock if the risk premium is high, but more stocks if the risk premium is low. Further, a rate of return guarantee provided at no cost to the plan participant induces him to hold more stocks, with or without regret. We also show that, with or without regret, investors’ willingness to pay for a guarantee rises with the level of the guaranteed return. This research could be informative regarding the potential profitability of the guaranteed pension business, which would help determine whether a government subsidy would be required to bring these products to market.
Muermann, Alexander, Mitchell, Olivia S., and Volkman, Jaqueline. “Regret, Portfolio Choice, and Guarantees in Defined Contribution Schemes.” Insurance: Mathematics and Economics. 39 (2006) 219–229.
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Paper IDWP 2003-060