Extrapolative Expectations and Retirement Savings

Abstract

Why do employees' retirement contributions gradually increase throughout their careers? This paper uses a structural life-cycle model based on household expectations data to explain workers' retirement contribution decisions. The Michigan Survey of Consumers data shows that young households extrapolate from their recent income realizations and overstate the persistence and volatility of their future income. The structural life-cycle model with extrapolative expectations quantifies the difference in retirement contribution rates compared to rational expectations. Contrary to rational workers, extrapolative workers' contributions match the data on retirement contributions over the life cycle. Consequently, mandating automatic enrollment yields negligible effects on retirement savings.

Keywords: extrapolative expectations, forecast errors, illiquid savings, retirement contribution

JEL Classification: E21, J26, J32