Rules of Thumb and Retirement Accounts

Abstract

We examine the welfare costs of applying common rules of thumb for saving, investment, 401k contributions, and withdrawals in an environment that includes a realistic treatment of taxation, Social Security benefits, 401k-plan details, and uncertainty in income, longevity, and asset returns. We test the performance of commonly recommended rules, such as investing 100-minus-age percent of assets in stocks, contributing 6–10% of income to a 401k account, or withdrawing the required minimum distribution (RMD) during retirement. We find that target-date rules for asset allocation generate moderate welfare losses, with one-time compensating variation amounts in the $1,500–$5,000 range for 401k allocation and $600–$1,300 for outside savings. Rules of thumb for 401k contributions generate even smaller welfare losses, in the $300–$500 range, reflecting the fact that the matching limit on 401ks provides a strong incentive to save at the threshold for many years of the working life. Withdrawing exactly the RMD proves to be a less successful strategy, though a compound strategy of withdrawing the maximum of a fixed percentage and the RMD is more effective. More generally, we find that rules of thumb may be reasonable alternatives to optimal decisions if the costs of optimizing are sufficiently high.

Keywords: Portfolio choice, risk and uncertainty, precautionary saving, household finance, 401(k) plans, life-cycle saving

JEL Classification: D15, G11, G51, G53