On the Asset Allocation of a Default Pension Fund

• Published date: 01 August 2018
• Author: MAGNUS DAHLQUIST,ROINE VESTMAN,OFER SETTY
• DOI: http://doi.org/10.1111/jofi.12697
• Date: 01 August 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 4 •AUGUST 2018

On the Asset Allocation of a Default

Pension Fund

MAGNUS DAHLQUIST, OFER SETTY, and ROINE VESTMAN∗

ABSTRACT

We characterize the optimal default fund in a defined contribution (DC) pension

plan. Using detailed data on individuals’ holdings inside and outside the pension

system, we find substantial heterogeneity within and between passive and active

investors in terms of labor income, financial wealth, and stock market participation.

We build a life-cycle consumption-savings model, with a DC pension account and

an opt-out/default choice, that produces realistic investor heterogeneity. Relative to

a common age-based allocation, implementing the optimal default asset allocation

implies a welfare gain of 1.5% during retirement. Much of the gain is attainable with

a simple rule of thumb.

THE WORLDWIDE SHIFT FROM DEFINED benefit (DB) to defined contribution (DC)

pension plans challenges pension investors, who have been given greater re-

sponsibility to choose their contribution rates and manage their asset alloca-

tions. Many investors seem uninterested, display inertia (Madrian and Shea

(2001)), or lack financial literacy (Lusardi and Mitchell (2014)), ending up in

the default option. Consequently, the design of the default option in a pension

plan may be a powerful tool for improving investment outcomes.1

∗Magnus Dahlquist is with the Stockholm School of Economics and CEPR. Ofer Setty is with

Tel Aviv University. Roine Vestman is with Stockholm University. The first version of this paper

was circulated under the title “On the Design of a Default Pension Fund.” We have benefited from

the comments of John Campbell, Christopher Carroll, Jo˜

ao Cocco, Pierre Collin-Dufresne, Anthony

Cookson, Frank de Jong, Francisco Gomes, Michael Haliassos, John Hassler,Harrison Hong, Seoy-

oung Kim, Samuli Kn¨

upfer, Per Krusell, Deborah Lucas, Robert Merton, Alexander Michaelides,

Stefan Nagel, Theo Nijman, Kim Peijnenburg, Ole Settergren, Clemens Sialm, Paolo Sodini, Kjetil

Storesletten, Annika Sund´

en, Carsten Sørensen, Amir Yaron,two anonymous referees, and partic-

ipants in various seminars and conferences. We thank Oren Sarig for excellentresearch assistance.

The research leading to these results received funding from the People Programme (Marie Curie

Actions) of the European Union’s Seventh Framework Programme (FP7), 2010–2013, under REA

grant agreement number 276770. Financial support from the Jan Wallander and Tom Hedelius

Foundation and the NBER Household Finance working group is gratefully acknowledged. The

hospitality of the Swedish House of Finance is also gratefully acknowledged. We have read the

Journal of Finance’s disclosure policy and have no conflict of interest to disclose.

1Prior studies examine the design of the enrollment features (Carroll et al. (2009)), contribution

rates (Madrian and Shea (2001), Choi et al. (2003)), choice menus (Cronqvist and Thaler (2004)),

and equity exposures of pension plans (Benartzi and Thaler (2001), Huberman and Jiang (2006)).

Benartzi and Thaler (2007) review heuristics and biases in retirement savings behavior. More

recently, Chetty et al. (2014) document inertia among pension investors with respect to their con-

DOI: 10.1111/jofi.12697

1893

1894 The Journal of Finance R

This paper studies one important aspect of the design of the default pension

fund—the optimal asset allocation. The asset allocation is particularly well

suited to the design of an individualized default fund as the optimal alloca-

tion decision requires knowledge of asset classes and financial literacy, while

knowledge of the optimal contribution rate may be known only by the individ-

ual (Carroll et al. (2009), Choi, Laibson, and Madrian (2010)). We make both

an empirical and a theoretical contribution to this literature. We begin by con-

structing a data set of Swedish investors’ detailed asset holdings inside and

outside the pension system.2We find that remaining in the default fund, or

not changing funds for a long time after an initial opt-out decision, is a strong

indicator of having no equity exposure outside the pension system. These pas-

sive investors’ stock market participation rate outside the pension system is

16 percentage points lower than that of active investors, with one-third of the

difference not explained by observable characteristics such as labor income,

financial wealth, and education. Overall, passive investors can be character-

ized as less sophisticated. Moreover, we find considerable heterogeneity among

passive investors. Passive investors participating in the stock market have

financial wealth equal to 1.4 years of labor income, while passive investors

not participating in the stock market have financial wealth equal to only five

months of labor income. Similarly, participating passive investors have 4.3

times as much financial wealth as nonparticipating passive investors. These

basic facts call into question the ability of a one-size-fits-all default fund to

meet all passive investors’ needs.

Motivated by these findings, we develop a model to study the optimal asset

allocation of passive investors’ default fund. Our model belongs to the class

of life-cycle portfolio choice models with risky labor income (see, for example,

Viceira (2001), Cocco, Gomes, and Maenhout (2005), Gomes and Michaelides

(2005)), meaning that it generates cross-sectional heterogeneity in income and

wealth. We extend the model to include a pension system with a DC pension

account, so that illiquid savings inside the pension system coexist with liq-

uid savings outside it. The decision of whether to be active or passive in the

DC pension account and the decision of whether to participate in the stock

market outside the pension system are endogenous but subject to costs. We

justify a dispersion in costs with heterogeneity in financial literacy and finan-

cial sophistication (e.g., experience making investment decisions and various

costs associated with investing). While endogenous stock market participation

is standard in the literature, our model is the first to endogenously determine

the passive pension investors who remain in the default fund.

tribution rates, Poterba (2014) discuss the savings rates required to obtain warranted replacement

rates, and Sialm, Starks, and Zhang (2015) argue that sponsors of DC plans should adjust plan

options to overcome investor inertia.

2Calvet, Campbell, and Sodini (2007,2009) use data on asset holdings outside the pension

system. Tothe best of our knowledge, we are the first to combine these register-based data with in-

formation about savings inside the pension system. Bergstresser and Poterba (2004) and Christelis,

Georgarakos, and Haliassos (2011) use survey data when studying equity exposure and location

choice between taxable and tax-deferred accounts.

On the Asset Allocation of a Default Pension Fund 1895

The model provides a normative suggestion regarding the asset allocation

in the default fund. We find substantial cross-sectional heterogeneity in the

optimal DC equity share: the year before retirement, 10% of default investors

have an optimal DC equity share of 39% or more, while 10% of default investors

have an optimal DC equity share of 9% or less. We also find that the optimal

DC equity share varies substantially with past stock market performance: from

the perspective of a 25-year-old, there is a 10% probability that the optimal DC

equity share will be 34% or more in the year before retirement, and a 10%

probability that it will be 20% or less. The latter result implies that different

birth cohorts’ optimal DC equity share depends on realized returns during the

different cohorts’ working phase. Conceptually, the optimal equity exposure in

an individual’s DC account depends on the account balance relative to both the

individual’s financial wealth outside the pension system and the present value

of the individual’s future labor income (Merton (1971)). This means that the

DC account balance is a useful guide for active rebalancing. For example, if

the account balance is low (high) due to poor (good) past equity returns, more

(less) equity risk can be assumed. The same reasoning applies to idiosyncratic

labor income shocks.

That passive and active investors are endogenously determined in the model

is important. As in Carroll et al. (2009), the composition of passive investors

endogenously adapts to changes in the default fund design. In this paper, the

design feature of interest is the asset allocation. We examine how the share

of passive investors changes as the degree to which the default is customized

to individual circumstances increases. Starting from a common age-based in-

vesting rule (i.e., the percentage allocated to equity is equal to 100 minus

one’s age), we find that a simple rule of thumb conditioned on the investor’s

age, DC account balance, and stock market participation status reduces the

share of active investors (who opt out) by 16.6 percentage points. Moreover,

we find that this rule can be robustly estimated across different samples of

default investors. This suggests that the rule is flexible enough to accommo-

date default investors who come from different institutional settings and initial

designs.

In terms of welfare gains, moving from age-based investing to full customiza-

tion of the default fund implies individual gains in certainty-equivalent con-

sumption on the range of 0.9% to 2.9% during the retirement phase, with an

average gain of 1.5%. Much of the average gain, 0.9%, is attainable if the pro-

posed rule of thumb is implemented. To put the gain from the rule of thumb

in perspective, we find that shifting from the best age-based asset allocation

rule to the rule of thumb implies a gain of 0.6%. In contrast, shifting from

the best constant asset allocation to the best age-based asset allocation im-

plies a gain of 0.4%. Thus, implementing the rule of thumb can add as much

value as implementing age-based glide paths for the equity share or intro-

ducing target dates. Another noteworthy observation is that, in our partial

equilibrium setting, such a change to the default fund’s asset allocation is

Pareto-improving: from an ex ante perspective, there are only winners and no

losers.