Towards Understanding Life Cycle Saving Of Boundedly Rational Agents: A Model With Feasibility Goals - Replaced by CentER Discussion Paper 2010-138

This paper develops a new life cycle model that aims to describe the savings and asset allocation decisions of boundedly rational agents. The paper’s main theoretical contribution is the provision of a simple, tractable and parsimonious framework within which agents make forward looking decisions in the absence of full contingent planning. Instead, agents pursue two simple so-called feasibility goals. The paper uses this framework to shed light on important empirical patterns of asset allocation that are puzzling from the point of view of existing models.Behavioral economics;bounded rationality;equity shares;feasibility goals;life cycle saving;stock market participation

A Simple Bounded-Rationality Life Cycle Model

Life cycle saving decisions belong to the most complex financial decisions that we are faced with in our life. Psychologists have found that when making complex decisions people use short-cuts in the form of minimum requirements for particular attribute categories of choice options. This paper presents a new simple life cycle model where agents do invoke such minimum requirements. The model is highly tractable and parsimonious. Calibrations show that it allows us to better understand important data on saving and asset allocation. It is shown that the model is much better able to explain these data than standard workhorse models even when generously controlling for subtle differences in the “degrees of freedom” between the new and existing models.Asset allocation;behavioral economics;bounded rationality;life cycle saving;noncompensatory decision making;threshold goals

Risk Management of Pension Systems from the Perspective of Loss Aversion

This paper studies pension design from a risk management point of view using a lexicographic loss aversion model. Interest in this model stems from the fact that it explains income expansion paths of equity and total savings particularly well. I find that all income groups are likely to benefit from a PAYGO system, even in the absence of any redistribution. Optimal equity investments are close to zero for the two bottom income quintiles and increase sharply for higher incomes. The results are compared to optimal pension plans under HARA preferences. I find that a PAYGO system has higher value under loss aversion than in the HARA case. Moreover, equity shares correspond more closely to empirical observations.pension system, portfolio choice, income heterogeneity, loss aversion, HARA preferences

Empowering Rural People for Their Own Development

This Elmhirst lecture first discusses the features of the institutional environment which allow rural people in low income countries to design, plan and implement their own rural development. These are divided into two broad groups: the institutional environment for rural development (environment for the private sector, communities and civil society, local government, and sector institutions) and the many factors governing profitability of investment in agriculture. While in many poor countries the institutional environment has improved over the last 20 years, the most poorly performing countries still have by far the poorest environment for local government in the world. Within an empowering institutional environment, the rate of agricultural and rural development is determined by investments of many different types that in turn depend primarily on the profitability of agriculture. The paper discusses the large number of factors which determine profitability. Few of these are under the direct control of farmers or agricultural sector institutions, but depend on governance and investments in other sectors such as trade and transport. In many of the poorest countries there has been considerable improvement in macroeconomic management and sector policies over the past 20 years, but progress in international and intra-regional trade policies, in agricultural trade policies, in transport infrastructure, and in agricultural research and extension have been limited.Community/Rural/Urban Development,

Imperfect Information, Democracy, and Populism

The modern world is complex and difficult to understand for voters, who may hold beliefs that are at variance with reality. Politicians face incentives to pander to voters' beliefs to get reelected. We analyze the welfare effects of this pandering and show that it entails both costs and benefits. Moreover, we explore optimal constitutional design in the presence of imperfect information about how the world works. We compare indirect democracy to direct democracy and to delegation of policy making to independent agents. We find that indirect democracy is often welfare maximizing.Imperfect information;beliefs;democracy;populism;accountabil- ity;experts

What is an Adequate Standard of Living During Retirement?

Many economists and policy-makers argue that households do not save enough to maintain an adequate standard of living during retirement. However, there is no consensus on the answer to the underlying question what this standard should be, despite the fact that it is crucial for the design of saving incentives and pension reforms. We address this question with a survey, individually tailored to each respondent’s financial situation, conducted both in the U.S. and the Netherlands. Key findings are that adequate levels of retirement spending exceed 70 percent of working life spending, and minimum acceptable replacement rates depend strongly on income.Life cycle preferences;pension reform;replacement rates;retirement saving

How Real People Make Long-Term Decisions: The Case of Retirement Preparation

A canonical but untested assumption in economics is that choices are determined only by preferences and budget constraints, but not by how people approach decision making. In particular, it is believed that people behave “as if they optimized”, even if they do not engage in any formal planning. We test this empirically in the domain of retirement saving using a specifically designed survey. We find that people who rely on a rule of thumb indeed behave like literal planners/optimizers. However, people without any systematic approach save substantially less. We discuss the implications of this finding.Decision process;planning;rule of thumb;retirement saving;household finance

The Role of Desicion Making Processes in the Correlation between Wealth and Health

There are many pathways explaining the relationship between socioeconomic status and health; one possibility is that some normally unobservable characteristic causes people to invest both in their financial well-being and their health. Here we consider the possibility that the decision making processes are similar across domains and that the steps individuals take to make decisions can help to explain the correlation in outcomes across domains. We focus particularly on retirement savings decisions and decisions in the health domain. Choices in both domains have long-term consequences and therefore require foresight and the ability to process complex information. Our results suggest that up to 44% of the correlation between wealth and health is due to the processes that people use to make these choices.Health;Wealth;Decision Making

The Miracle of Compound Interest: Does our Intuition Fail?

When it comes to estimating the benefits of long-term savings, many people rely on their intuition. Focusing on the domain of retirement savings, we use a randomized experiment to explore people’s intuition about how money accumulates over time. We ask half of our sample to estimate future consumption given savings (the forward perspective). The other half of the sample is asked to estimate savings given future consumption (the backward perspective). From an economic point of view, both subsamples are asked identical questions. However, we discover a large “direction bias”: the perceived benefits of long-term savings are substantially higher when individuals adopt a backward perspective. Our findings have important impli- cations for economic modeling, in general, and for structuring advice and financial literacy programs, in particular.Behavioral economics;financial intuition;financial literacy;com- pound interest;retirement saving

The impact of formal finance on the rural economy of India

India has systematically pursued a supply-led approach to increasing agriculturalcredit. Its objectives have been to replace moneylenders, to relieve farmers of indebtedness, and to achieve higher levels of agricultural credit, investment, and output. India's success in replacing moneylenders has been outstanding. Between 1951 and 1971 their share of rural credit appears to have dropped from more than 80 percent to 36 percent. (It may have dropped to as low as 16 percent by 1981, but that estimate is disputed). Still, institutional credit is far from reaching all farmers. Only about a quarter of cultivators borrow, and no more than 2 percent take out long-term loans. Most small farmers have little access to credit, and long-term credit goes mostly to large farmers. Overall, farm debt has probably not increased sharply in real terms, as formal credit has primarily substituted for credit from other sources. Moreover, with the rapid growth of commercial banks in the 1970s, the system mobilized more deposits than it lent in rural areas in 1981. Of course, enhanced deposit services are a useful service of the rural population, but one must ask what has been the impact of heavy rural credit and better financial services on agricultural investment, production, and rural incomes. The authors'econometric results suggest that the rapid expansion of commercial banks in rural areas has had a substantially positive effect on rural nonfarm employment and output. The availability of better banking facilities appears to have overcome one of the obstacles to locating nonfarm activities in rural areas. Expanded rural finance has had less of an effect on output and employment in agriculture than in the nonfarm sector. The effect on crop output has not been great, despite the fact that credit to agricluture has greatly increased the use of fertilizer and private investment in machines and livestock. There has been more impact on inputs than on output, so the additional capital investment has been more important in substituting for agriclutural labor than in increasing crop output. But overall, rural credit and expansion of the rural financial system have had a positive effect on rural wages. Creating nonfarm jobs has apparently added more to total employment than the substitution of capital for labor has subtracted it in agriculture. So, wages have risen even for agricultural workers, albeit modestly. The supply-led approach to agricultural credit that has been pursued for three decades has clearly benefited current borrowers and farm households formerly indebted to moneylenders. It has also spurred fertilizer use and investment in agriculture. It has been less successful in generating viable institutions - and has failed to generate agricultural employment. The policy's costs to India's government have been high as portfolio losses associated with poor repayment ultimately have to be borne by the government or one of its institutions under optimistic assumptions. The benefits of the agricultural income are at best no more than 13 percent higher than the cost to the government of the extra agricultural credit. If assumptions about the cost of supplying the credit and about repayment rates are less optimistic, the social costs - and the costs to the government of providing the credit - would have exceeded the benefits in agricultural income. The expansion of commercial banks to rural areas paid off in nonfarm growth, employment, and rural wages. The question is: Could these benefits have been achieved without imposing agricultural credit targets on the commercial banks and credit cooperatives? Or did the commercial banks expand only because they were forced to lend to agriculture? The authors could not answer these questions with the data at hand.Banks&Banking Reform,Environmental Economics&Policies,Financial Intermediation,Economic Theory&Research,Agricultural Research