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INVESTING RETIREMENT WEALTH: A LIFE-CYCLE MODEL – Welfare Analysis 4

INVESTING RETIREMENT WEALTH: A LIFE-CYCLE MODEL - Welfare Analysis 4The top panel of Table 9 repeats the first three rows of Table 7 for the benchmark case. The second and third panels consider two alternative scenarios in which the equity premium is 1 percentage point lower at 3%. In the first alternative, the equity premium falls but the riskless interest rate is unchanged, so the expected equity return falls by 1 percentage point. This is a scenario envisaged by critics of Social Security investment in equities who worry that such a reform would drive up stock prices and drive down expected stock returns. In the second alternative, the equity premium falls but the riskless interest rate rises by 1 percentage point, leaving the expected equity return unchanged. This scenario is predicted by general equilibrium models in which the return to risky capital is fixed by technology, such as Cox, Ingersoll, and Ross (1985) or Abel (1999).
Within each of the alternative scenarios, the welfare gains produced by risky investment of retirement wealth are similar to but slightly smaller than those in the benchmark case. In the rows marked with double asterisks, Table 9 compares welfare in the alternative scenarios with risky investment of retirement wealth, to welfare in the benchmark case with riskless investment of retirement wealth. This is a crude way to capture the possibility that risky investment of retirement wealth might lower the equity premium. It turns out that the results are critically dependent on the way in which the equity premium falls. If it falls through lower stock returns, as in the first alternative, then welfare gains are reduced from 3.7% to 2.8%. If it falls through a higher riskless rate, as in the second alternative, then welfare gains are actually increased to 5.0%.
Decisions about the quantity and form of retirement saving are among the most important that a typical household takes in the course of a lifetime. Despite the importance of the issue, until very recently financial economists have had little quantitative understanding of the factors that should affect this decision. This gap in our knowledge has made it hard to give sound advice to policymakers considering reforms in retirement systems.
In this paper we have built a partial-equilibrium life-cycle model that can be used to explore the properties of alternative systems. In our benchmark case, we find a welfare gain equivalent to 3.7% of consumption from the investment of half of retirement wealth into equities, accompanied by a reduction in the Social Security tax rate to maintain the same average replacement rate of income in retirement. The main channel through which these gains are realized is that a lower Social Security tax rate helps households smooth their consumption over the life cycle. The gains from equity investment of retirement wealth are smaller, about 0.5% of consumption, when the Social Security tax rate is held constant at its initial level. Interestingly, in our model particularly risk-averse households are particularly keen to smooth consumption and thus experience even larger gains from reduced tax rates made possible by equity returns on retirement wealth. This is true despite the fact that risk-averse households are less enthusiastic equity investors.