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Are lifecycle funds appropriate as default options in participant-directed retirement plans?

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  • Basu, Anup K.
  • Chen, En Te
  • Clements, Adam

Abstract

Since the enactment of Pension Protection Act of 2006, lifecycle funds that reduce exposure to stocks with age have rapidly replaced money market funds as the most commonly nominated default investment options for participant-directed retirement plans. We examine their appropriateness in meeting a threshold level of retirement wealth required by plan participants. Using a utility function motivated by prospect theory (Kahneman and Tversky, 1979), we show that whilst lifecycle funds are vastly superior to money market funds (except for very low thresholds), they rank below balanced funds that maintain constant exposure to equities over time. As thresholds increase, lifecycle funds are also dominated by funds that switch assets conditional to prior investment performance. Even in the absence of a minimum threshold wealth level, lifecycle funds do not emerge as the most preferred choice among the investment options considered by our paper.

Suggested Citation

  • Basu, Anup K. & Chen, En Te & Clements, Adam, 2014. "Are lifecycle funds appropriate as default options in participant-directed retirement plans?," Economics Letters, Elsevier, vol. 124(1), pages 51-54.
    • Handle: RePEc:eee:ecolet:v:124:y:2014:i:1:p:51-54
    DOI: 10.1016/j.econlet.2014.04.020
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    References listed on IDEAS

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    1. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    2. Shiller Robert J., 2005. "Life-Cycle Portfolios as Government Policy," The Economists' Voice, De Gruyter, vol. 2(1), pages 1-9, August.
    3. Poterba, James & Rauh, Joshua & Venti, Steven & Wise, David, 2007. "Defined contribution plans, defined benefit plans, and the accumulation of retirement wealth," Journal of Public Economics, Elsevier, vol. 91(10), pages 2062-2086, November.
    4. Michael E. Drew & Anup Basu & Alistair Byrnes, 2009. "Dynamic Lifecycle Strategies for Target Date Retirement Funds," Discussion Papers in Finance finance:200902, Griffith University, Department of Accounting, Finance and Economics.
    5. David A. Wise, 2009. "Developments in the Economics of Aging," NBER Books, National Bureau of Economic Research, Inc, number wise09-1.
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    Cited by:

    1. Wiafe, Osei K. & Basu, Anup K. & Chen, En Te, 2020. "Portfolio choice after retirement: Should self-annuitisation strategies hold more equities?," Economic Analysis and Policy, Elsevier, vol. 65(C), pages 241-255.

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    More about this item

    Keywords

    Default option; Lifecycle funds; Retirement wealth; Asset allocation; Prospect theory;
    All these keywords.

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies
    • J32 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Nonwage Labor Costs and Benefits; Retirement Plans; Private Pensions

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